Opportunities Funds Commentary

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UPDATE
Trident Investment Management, LLC
Opportunities Funds Commentary
October 31, 2010
Peformance Discussion
October proved to be another bullish month for equities. The S&P 500 Index was up 3.69%, and the MSCI Europe
Index was up 2.40% but the Nikkei was down 1.78%. Commodities were also strong with gold rising 3.9% to end
at $1,359.4 an ounce and oil rallying 1.83% to end at $81.43 a barrel. Bonds were mixed. U.S. Treasury yields were
largely unchanged on the month, but some overseas markets such as Australia saw a continued rise in rates with 2-year
swap rates in the latter rising 0.14% to end at 5.18%. Credit markets remained strong as well with spreads on U.S.
Investment Grade bonds tightening by 0.12% to end at 0.95% per annum. The U.S. dollar continued to act poorly,
much as it did in September with the U.S. Dollar Index depreciating 1.85% on the month (all figures in U.S. dollars).
We were slightly up in October, but not enough to compensate for our September losses. Our long position in U.S.
curve steepeners and gold contributed significantly to our performance as did our short positions against the U.S.
dollar. However, we were hurt by our long positions in Australian fixed-income options, which moved against us
considerably, due to a move up in rates and a decline in volatility. On the trading front, we were relatively quiet. The
only positions we have been adding to are our shorts against the U.S. dollar since we expect that the U.S. Federal
Reserve’s policies to result ultimately in a much weaker dollar.
Market Outlook and Portfolio Strategy
Markets have been buoyant over the last several weeks thanks to expectations of continued quantitative easing by the
U.S. Federal Reserve. All news good and bad has been taken as bullish with good information positive for markets
and bad data suggestive of even more Fed quantitative easing. Unfortunately, the fundamentals do not provide a
strong foundation for the bullish view. Economic data of late have been largely mediocre and political developments
even worse. While third quarter corporate earnings for some sectors have been robust, they have proved disastrous
for the financial firms, which make up the largest single part of the U.S. equity market. The increasing disconnect
between the facts and the markets suggests that the Fed is succeeding in creating a bubble in stocks and very likely
also in bonds and credit. Unfortunately, given its horrendous track record of bubble creation since 1998, first with
technology and then real estate and credit, the results of the current experiment are all too predictable.
Outside the exchange rate, the financial system is the main avenue through which any benefits of quantitative easing
in the form of increased leverage or investment should be transmitted. Thus, the health of the financial sector merits
close examination. The third-quarter earnings of the sector suggest that it faces huge revenue headwinds. Brokerage
and investment banking revenues were down significantly, in some case as much as 50%, even as net interest
margins fell in traditional banking. However, while these declines were much worse than markets had expected, the
financial firms nevertheless met or beat earnings expectations for the most part because virtually all of them reduced
provisioning against loan losses on the grounds that the economy was going to do much better. In fact, absent these
reductions in provisions, many of our largest banks might have reported losses in the third quarter. The difficult
revenue environment faced by our financial firms could soon be overshadowed by an even bigger problem that should
aptly be called “Foreclosure-Gate”. We discuss this new scandal at some length below because it has the potential to
grow into a full-blown crisis that could well prove the last straw that breaks the back of the financial system.
Our discussion below first considers how the mortgage and foreclosure processes worked in the period up to the late
1980s. We then consider how the process has evolved thanks to the financial innovations especially in securitization.
Next we consider how our financial system has actively flaunted its own rules and regulations leading to the current
Foreclose-gate crisis. And lastly, we examine the role of the Fed and try to put its QE programs in context.
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UPDATE
1. The Classic Mortgage Process
When a borrower takes out a mortgage loan to buy real estate, there are two required pieces of documentation that
accompany it. First there is the promissory note that is the written promise to repay the loan subject to the terms
agreed upon by the borrower and lender. Next, there is the actual mortgage which is a lien on the real estate to
secure the loan. Typically, the mortgage is a public document and gives any subsequent purchaser notice that an
obligation exists on the real estate. When the loan is repaid in full subject to the terms of the promissory note, the lien
is discharged. The important point is that the promissory note is the actual evidence of the debt. The mortgage itself
becomes relevant only when the borrower does not perform according to the terms laid out in the promissory note.
The classic mortgage process of yesteryear in the U.S. involved a potential home buyer’s going to his local bank to
obtain a mortgage loan. The bank’s loan officer would determine the borrower’s financial condition obtaining all
the documentation necessary to do the same, and also assess the value of the property that would serve as security
for the loan using reliable independent appraisers. Armed with these data, the loan officer would be in a position
to determine the maximum amount the bank was prepared to lend against the property subject to its internal risk
guidelines. Typically, the bank held the loan made to maturity. Given that its money was at risk, the lender would
periodically review the loan and the borrower’s financial condition to make sure it could be reasonably certain of
getting repaid. Moreover, when a borrower was faced with financial distress, the loan officer, who typically had
personal knowledge of the loan, was in a position to evaluate the borrower’s condition and determine whether any
payment postponements or relief might be appropriate given the circumstances. After all the process of foreclosure
meant the loss of a home to the borrower, as well as a significant loss to the lender and both parties were incentivized
to seek the least painful resolution of a problem loan. When a loan required foreclosure, most courts required the a
bank representative to represent that he had personal knowledge of the loan and the borrower’s delinquent status, a
requirement that was not onerous given the loan officer’s involvement with the whole process.
2. The Modern Mortgage Process
The mortgage process of today bears little resemblance to the classic mortgage process. Many of the loans today are
originated by a mortgage broker who works with a bank or group of banks and often is an actual employee of the
bank. The originator identifies the potential borrower, obtains the documentation to determine the eligibility of the
latter for a loan, appraises the property to be purchased using a network of qualified appraisers and then presents this
package of information to the lending bank or banks. The bank reviews the documentation and its veracity, obtains
other information as needed, and then decides on the terms of the loan to be made if any. The originator however
gets paid only when a transaction is consummated. As such, he has a vested interest in making sure that any and every
borrower can qualify for a loan.
The bank making the loan today usually does not hold it to maturity. In fact, the firm usually warehouses the
loan for a period of 30 to 60 days and then pools several of them into a securitized vehicle that can be sold to the
capital markets. Most banks also do not provide the post-lending services for the mortgage which include collecting
payments, responding to inquires, dealing with delinquent borrowers and the like, outsourcing these activities instead
to specialized mortgage servicer firms. Thus, the banks have evolved from being true lenders that were involved in
every step of the mortgage process to just being short-term bridge loan providers for housing finance.
3. The Mechanics of Securitization
The transformation of the classic mortgage process has been largely a consequence of the increasing importance
of securitization. The securitization market for housing loans was pioneered by Ginnie Mae (an arm of the U.S.
government) and the government sponsored agencies, Fannie Mae and Freddie Mac.
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UPDATE
The simplest form of securitization occurs when a bank pools together a group of mortgages that meet certain
criteria regarding lending rates, down payments, loan to value ratios and the like that are set by the above government
agencies. The pool is transferred to the government institution which gives the bank pass-through certificates in
return. A pass-through certificate is a bond whose cash-flows are “passed through” (after fees) from the mortgages in
the pool and is one of the simplest examples of the so-called Mortgage Backed Security (MBS). Holders of the bond
receive cash-flows pro-rata based on the size of their holding and do not have to worry about defaults because the
government agency guarantees it against default by any component mortgage. Therefore the MBS is standardized,
backed by the credibility of the insuring government agency and is considerably easier to transact in the public
markets than the underlying individual mortgages. For these reasons, securitization has come to dominate housing
finance. Many banks often securitize even loans that they intend to hold to maturity because of the flexibility it gives
them on asset/liability management.
While the simple structure above has represented a huge part of the overall securitization market over the years,
banks also made numerous housing loans that were not eligible for government agency guarantees, especially since
2002. Most subprime loans, no-documentation or “liar loans” and other similar loans could not be securitized using
the government agencies so the banks devised complex, risk-sharing securitization structures that permitted such
instruments to be sold to the capital markets.
Securitizations are governed by a host of rules driven both by banking regulators and the US tax code. Care had to be
taken in performing the securitization to ensure that purchasers of the MBS had clear title to the mortgage pool even
if the originating bank were to fail. Specific rules also governed whether a securitization was treated as a financing
or a sale by the issuing bank. Improperly executed securitizations could subject the bondholders or the banks to
significant, unexpected tax liabilities.
Consider a simple securitization involving a single pool of mortgages. Executing this securitization involves the
following steps, (and these are generally applicable to most securitizations):
1) A special purpose vehicle (SPV) or company has to be created to hold the pool of mortgages and the SPV is the
one that will issue the bonds or MBS. The originating bank has to transfer title of the pool of mortgages to the SPV.
2) The SPV creates an offering document for the bonds to be sold against the mortgage collateral.
3) The SPV appoints a trustee whose job is to safeguard the mortgage assets, cash etc. for the bondholders. The
trustee has to ensure within a few days of the bond issuance that all the mortgage collateral has been transferred
properly into the SPV, and that the collateral satisfies the criteria laid out in the offering documents. If it does not,
the trustee has the obligation to ensure that the bank takes back the faulty collateral at par.
4) The SPV hires a servicer to service the mortgage loan assets transferred from the originator. The servicer has
to deal with the actual borrower henceforth making decisions on loan forgiveness, foreclosures, etc. as required.
5) The SPV appoints underwriters (or arrangers) to sell its bonds to the public. The underwriters are required to
perform due diligence to verify that the transaction is consistent with the offering documents. In particular, they
need to verify that the characteristics of the mortgage loans in the SPV are consistent with the description in the
offering documents.
6) The SPV and the underwriters may hire a rating agency to provide a rating for the bonds. The agency will have
to perform its own diligence to ensure that the bonds are as described in the SPV documents and that they receive
the ratings appropriate for their risk.
In the securitization above, the ultimate purchaser of the MBS issued by the newly-created SPV ends up paying the
fees for the trustee, the servicer, the underwriter and the ratings agency. As such, all of these parties are expected to
work in the interest of the bondholders and only the bondholders.
The financial crisis that arose in 2007-2008 was at least partially due to the fact that most banks ceased to be prudent
lenders but instead focused on maximizing the number of securitization transactions, with the expectation that they
2010
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UPDATE
would have no borrower-monitoring role post the transaction. Unfortunately, in the headlong rush to maximize
transactions, many participants in the financial food chain omitted to perform some of the basic securitization steps
above. Even worse, it appears that many of the agents representing bondholders failed to safeguard the latter’s interests.
These issues collectively have led to Foreclosure-Gate.
4. Foreclosure-Gate
The Foreclosure-Gate scandal came to light because of the record volume of foreclosures that followed the housing
bust of 2007-2008. With foreclosures, U.S. courts still assume the mortgage mechanics of the 1980s or earlier. An
individual from the foreclosing bank has to certify as to personal knowledge of the facts surrounding the loan and
the delinquency of the borrower and has to come to court armed with all the necessary documentation. In today’s
world, given the over-reliance on technology in the mortgage process along with specialization of duties, there is no
one individual at the lender (which for securitizations would be the servicer who performs the post-lending functions)
who can reasonably claim to have full knowledge of the issues surrounding an individual loan. In fact, given the
overwhelming number of delinquencies, most lenders have contracted with outside firms to perform these various
checks on the loan. The actual certification regarding the circumstances of the loan was executed by so-called “robosigners” who are bank representatives charged with affixing their signature to numerous foreclosure case files that
they were nominally “responsible” for. Given the requirements of most U.S. courts that the certifying agents have
personal knowledge of the foreclosure case, it is clear that our robo-signers were in violation of this rule. In fact, most
of these individuals signed off on tens of thousands of these foreclosure cases, certifying to personal knowledge that
they decidedly did not have. The very act of robo-signing thus, reflects perjury by the banks in court.
The robo-signing issue could be viewed as mere technicality of court procedure – after all, the facts regarding the
delinquency are still unchanged whatever the minor details. This is what our banks would like to have us believe.
However, it is becoming increasingly apparent that the robo-signing issue is only the tip of the iceberg – it hides far
deeper problems of fraudulent loans, careless or non-existent loan transfers, multiple pledging of the same mortgage
to different trusts and worst of all, an attempt to cover up problems after the fact. We take up each of these issues below.
4.1 Fraudulent Loans As the foreclosure problems mount, guarantors and bondholders in securitizations are beginning to realize that many
of the bad loans made by the banks were not just loans made by over-zealous loan officers, but might have been
part of a much broader rot in financial ethics. It appears that many banks may have made loans where much of the
data relating to the borrower’s income, assets, employment etc. were totally fabricated. Even a cursory examination
of these details would have revealed that the loan was not in compliance with the lender’s credit guidelines, if not
altogether fraudulent. Loans transferred by originators to securitizations typically carry representations and warranties
that they were underwritten to the lender’s credit standards. As such, it follows that these loans would not have been
eligible for securitization.
The offering documents for most securitizations and the agreements with most mortgage guarantors such as Fannie
Mae, typically have clauses that permit the bondholder or the guarantor to put back loans to the originating bank at
par when it appears that the loan did not satisfy the representations made by the lender. Not surprisingly, the put back
requests are mounting for the banks. Bank of America acknowledged a staggering $365 billion in put back requests
on loans that it had made with the bulk of these requests pertaining to loans acquired on its ill-advised takeover of
the poster-child for mortgage fraud, Countrywide Credit. It is clear that most of the major home lenders (which
includes all of the U.S.’ major banks) should be affected to a significant degree by such put back requests going
forward. Unfortunately, investors can only guess at the ultimate liability from these loans because most of them relate
to transactions which are not on the firms’ balance sheets any more.
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4.2 Bad Loan Transfers
UPDATE
In transferring loans to securitizations, the banks were required to sign over the promissory notes and the mortgage
lien along with supporting documentation. The servicers for the securitization and/or the trustee had to certify that
all the loan transfers were completed into the SPV typicially within 30-60 days of the deal’s closure. It appears that
these steps were skipped for many of the loans in these securitizations. Given that many of these transfers were done
improperly or not at all, the question is why the banks, and these agents, who were getting paid handsomely for their
services, failed to perform their duties, while certifying that they had.
When the promissory note is not transferred properly, it represents a major headache during foreclosure. The servicer
who represents the bondholder in the foreclosure has no legal standing at all in court if he cannot show that the
securitization SPV has legal title to the mortgage. Put differently, how can a creditor take a debtor to court if he cannot
even establish the existence of a debt owed to him? This issue is not a mere technicality that can be papered over and
is central to the problems of Foreclosure-gate. Any attempt by the government to favor the banks in such proceedings
would be a huge assault on the courts and contract law.
Establishing proper title to the mortgages in a securitization much after the deal has closed is a time-consuming and
problematic endeavor. Given the housing crisis, many of the intermediate parties to which the underlying mortgage
may have belonged have gone out of business. As such, establishing a full “chain of title” to the mortgage as required
by US courts from the originator all the way through to the current owner (the SPV) might prove a virtually impossible
task. Some of the banks and servicers have been trying to take the easy way out by fabricating such transfers after the
fact, and have been caught for this fraud by some of the more diligent courts.
A mitigating factor in this title problem is that the mortgage industry set up an electronic system for managing
the loans and their registrations called the Mortgage Electronic Registration System (MERS). MERS tracked loans
through the chain of ownership, but while it was a powerful electronic tool that simplified record-keeping, most U.S.
states require the original, duly transferred promissory notes as the basis for a claim to foreclose. Some lenders appear
to have relied entirely on MERS as the basis for loan transfers, in some cases even destroying the original promissory
notes and mortgage liens. However, while MERS itself may be perceived as a nominee holder of the mortgage,
most courts do not recognize it as such and require the actual holder of the mortgage loan to come forward with the
relevant documentation to foreclose. So, even if the banks can go with MERS as the holder of record, it is not clear
that the U.S. courts could, or for that matter, should accept this as an alternative to the signed promissory note. In
fact, even the management of MERS in a statement released on October 9, 2010 stated that lenders cannot hide
behind MERS for non transfer of mortgage documents into securitizations and non-compliance with statutes. Thus,
the whole problem with record-keeping in securitizations has revealed just how cavalier lenders and other financial
service providers had become about the whole process of securitization.
4.3 Improper Disclosure
The problems get even worse. Many banks and underwriters that arranged securitizations typically bought pools of
loans from numerous originating lenders. They often outsourced the diligence on these pools to specialized companies
such as Clayton Holdings, a mortgage analytics and consulting company. Clayton’s analysis of the loans was intended
to identify problem loans which were missing documents, failed to meet certain underwriting guidelines etc. By most
accounts, firms like Clayton appear to have performed their diligence capably, often revealing problems with the
loans to be purchased. The MBS issuers used these results to negotiate down the prices of the loans they bought from
originators. However, where it came to securitizing these very same loans, the issuers appear to have misrepresented
their characteristics in the offering documents, even when armed with the information provided by Clayton or other
such firms. Put more simply, the issuers were diligent when buying loans, but were happy to lie when selling them.
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4.4 Conflicts of Interest
UPDATE
The final question is why the trustees and servicers did not blow the whistle at least when it came to the procedural
failures that they were entrusted to check. Unfortunately, most of the servicers and trustees are owned by the banks
themselves, so that there is an automatic conflict of interest. Countrywide, for example, is the largest mortgage
servicer in the U.S., and is not surprisingly, unwilling to pursue its parent Bank of America aggressively where it
comes to mortgage fraud. The rest of the servicing and trustee industry is equally incestuous in its setup so that what
we have is an elaborate system that safeguards the interests of the financial system at the expense of the public at large.
Getting this corrupt system to work for bondholders is proving a difficult exercise – witness for example that Pimco,
Blackrock and the New York Fed have recently sued to force Bank of America to repurchase mortgages packed into
$47 billion worth of bonds. The lawsuit actually is to force Countrywide, the servicer, to perform its duties on behalf
of bondholders and put back fraudulent loans to lender Bank of America (originally lender Countrywide too!). Bank
of America is also arguing with the government agencies about put backs of fraudulent loans, while these agencies’
losses spiral into tens of billions of dollars this year. What is ludicrous in all this is that the Federal Reserve (and by
extension the NY Fed) is the primary regulator for the banking system and in particular Bank of America. Even worse,
the government has bailed out Bank of America, which could not continue to exist without government support.
Thus, huge amounts of taxpayer time and money are being expended to sue organizations that are de facto taxpayer
controlled and funded anyway.
5. The Role of the Federal Reserve
Given the central role of the Federal Reserve in the financial system, the question that should be asked is what exactly
the institution has been doing in the midst of all these problems. The Fed’s main responsibilities are in four main
areas (not in order of priority) as paraphrased from its own website. First, it is to conduct monetary policy in the
pursuit of stable prices and full employment. Next it is to supervise and regulate the banking system to ensure its safety
and soundness and protect consumers. Third is to maintain the stability of the financial system and contain systemic
risk. And finally, it is required to manage the payments system for the US and provide certain financial services to the
government and public.
With two of the four major responsibilities of the Fed relating to supervising the banking system and ensuring its
stability, what we have before us is a system which is riddled with fraud at every level with a group of compliant
regulators who are doing everything in their power to hide the truth. Former Fed Chairman Alan Greenspan felt
that the banks were “self-regulating”, whatever that might mean, and former NY Fed Chairman Tim Geithner (now
Treasury Secretary) actually testified that he had never been a regulator during his Treasury confirmation hearings.
Current chairman Bernanke has believed over the years that real estate prices could never decline, that the subprime
crisis was contained, that the U.S. financial system was in great shape, that QE1 worked, and finally that QE2 is going
to work.
With an amazing record of negligence and incompetence, it is not surprising that the Fed is embarking on Round 2 of
QE, to be followed no doubt by rounds 3 and more. The importance of more QE stems perhaps more from the Fed’s
desire to hide the very real problems facing the U.S. financial system, not to mention its own culpability. Unfortunately,
given the extremely poor state of the U.S. financial system, not to mention the over-leveraged consumer, it is unlikely
that QE can have the desired effects of boosting investment and/or increasing leverage to create a self sustaining
growth cycle. What QE2 will do is destabilize the rest of the world for reasons that we have already discussed at length
in previous communications. And our trading partners are not in rude health – the Europeans arguably, may be facing
even bigger problems in the near term than we do. So, in the interests of near-term obfuscation by our policymakers,
we are risking long-term immolation as an economy. Such a choice hardly inspires confidence.
It is depressing that over two years after the Lehman collapse, we are still struggling with a financial system on
life support, even as the employees and managements of the sector continue to receive record payouts. Virtually
2010
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UPDATE
every arena of financial activity we examine seems to be riddled with problems and fraud stemming from unethical
management and incompetent regulation. The system seems to be the veritable Lernaean Hydra (a sea monster with
virulent breath and nine heads that grew two new heads for every one that was cut off) that holds the U.S., if not the
world, in thrall. What we lack is a modern-day Hercules among our policymakers who can slay this destructive monster.
6. Conclusion
We believe strongly that the world economy has entered an especially dangerous phase. The problems in Europe
have not been resolved with Ireland, Greece, Portugal and other still in dire financial straits. The U.S. banking system
is once again facing serious difficulties with a double dip in housing having started already, with potentially more
problems to come with foreclosures and loan put backs. Despite these issues, the Fed believes that driving financial
markets up to bubble levels again with QE2 will solve the world’s problems and markets are only too eager to agree.
This has been tried repeatedly (with minor variations) by the Fed over the last decade, with increasingly unpleasant
results each time. Albert Einstein defined insanity as doing the same thing over and over again and expecting different
results. We know now that the markets are firmly in the control of the lunatics.
Performance Summary at October 31, 2010
Trident Global Opportunities Fund
1 Mth.
3 Mth.
6 Mth.
1 Yr.
2 Yr.
3 Yr.
5 Yr.
10 Yr.
YTD
Since Inception
(Feb. ‘01)
0.6%
0.7%
-4.2%
1.8%
14.5%
21.1%
N/A
-2.3%
12.0%
0.7%
CI Global Opportunities Fund
1 Mth.
3 Mth.
6 Mth.
1 Yr.
3 Yr.
5 Yr.
10 Yr.
15 Yr. YTD
Since Inception
(Mar. ‘95)
0.6%
0.6%
-3.9%
13.3%
22.8%
7.9%
18.6%
-2.2%
19.1%
0.7%
Nothing herein should be read to constitute an offer or solicitation by Trident Investment Management, LLC or its principal to provide investment
advisory services to any person or entity. This is not to be construed as a public offering of securities in any jurisdiction of Canada. The offering of
units of the Trident Global Opportunities Fund are made pursuant to the Offering Memorandum only to those investors in jurisdictions of Canada
who meet certain eligibility or minimum purchase requirements. Important information about the Funds, including a statement of the Fund’s
fundamental investment objective, is contained in the Offering Memorandum. Obtain a copy of the Offering Memorandum and read it carefully
before making an investment decision. These Funds are for sophisticated investors only. ®CI Investments and the CI Investments design are
registered trademarks of CI Investments Inc.
2010
OCT