Saturday, July 28, 2007

"Black Swan" Event for AHM

Earlier this month, I shared my thoughs about the underwriting at American Home Mortgage (copied below for your convenience):

And finally, some food for thought: American Home Mortgage, an Alt-A loan originator, recently withdrew its guidance for the year and said it expects a loss because of a large influx of warranty penalties. To clarify, when most loan originators sell a loan to an investor, they usually include a warranty that the loan will not go delinquent within the first three months, or otherwise the company will buy back the loan. Those following the subprime fiasco know that this was the cause of the downfall of New Century and several other lenders. (Delta Financial, on the other hand, has so far avoided this) The question is, if loan underwriting has gotten so bad that many loans are going bad in three months, how much better could the loans be that they wrote 6 months, a year, two years ago? The question is important considering subprime and Alt-A combined made up 40% of 2006 loan originations, and many loans written in the last few years are set to reset in the 07-09 period.

Well, late Friday afternoon American Home decided to delay dividend payments on their common and preferred shares in order to preserve liquidity. "The disruption in the credit markets in the past few weeks has been unprecedented in the company's experience and has caused major write-downs of its loan and security portfolios and consequently has caused significant margin calls with respect to its credit facilities."(my italics) So in other words, they were hit by one of Nassim Taleb's black swans: a rare, large-impact event that is beyond normal expectations. It's not that this credit tightening was unpredictable- anyone following the matter could have seen how poor loan standards had become and the future instability to come. But because the good times have been rolling for so long for the financial industry, many choose to ignore the possibility of a credit crunch. Now, those same firms are getting hit hard. I'm starting a new label entitled "Black Swan" that will keep track of the firms that will claim to have been struck by unprecendent, black swan type events
. My guess is the list will soon be pretty long.

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