To Our Clients, Colleagues and Friends:   

· Seems like almost every day another public company is raising capital.  But what about you smaller, privately owned companies?  Some of you are so thinly capitalized as to really scare us.  Many are just a few buy-backs away from insolvency.  We’d like to see more private owners invest in their own companies and put some more capital in. What puzzles us that many owners of smaller companies don’t want to put their own capital into their mortgage banking companies.  If you own, say, 100% of the company, what difference does it make if you have your money in a personal bank account, or invested in the stock of your company?  It doesn’t.  Put another way, how can you ask a warehouse lender to have confidence in your company if you, yourself, don’t have the confidence to invest in it.

· The Saturday Wall Street Journal shows cash prices for various commodities, and here are a few that caught our eye (we’ll skip the units of measurement):  Tin has gone from $872 a year ago to $1,536 today.  Soybeans have gone from $7,500 a year ago to $13,370 today. Wheat was $5.43 and is now $12.16. And corn oil has gone from $31.50 to $76.50.  Ouch.

· Hilarious quote from Mark McGuire back when he was hitting home runs and breaking records:  “I study pitchers. I visualize pitches.  That gives me a better chance every time I step into the batters box, and that’s the reason I’ve come a long way as a hitter.”  Um, Mark, didn’t you leave something out, something about steroids?

· The head of the FDIC said they will be tightening up on banks that are too reliant on wholesale funding. Translated, this means they want to see banks get core deposits from real customers and not just offer CD’s or be too reliant on FHLB borrowings.

· Today, May 20, 1818 is the birthday of William Fargo, co-founder of Wells, Fargo & Co.  We wonder if he and his partner argued over the name:  Wells, Fargo as opposed to Fargo, Wells.

· Despite the bloodbath this past year in Savings & Loan stocks, there have been winners.  Our hats off to the following thrifts:  Sistersville Bancorp (WV) up 68% in the past year, Hudson City Bancorp (NJ) up 46%, and Dime Community (NY) up 45%.

• We’ve noticed a slight trend in retail shops we’re in.  After being burned on aggressive appraisals, we’re seeing a few companies moving toward very slimmed down approved appraiser lists. We have one client with, literally, three approved appraisers.  Now, they’re obviously not huge, and we’re not even sure it’s a trend, but we like it.  A very limited number of appraisers whom the owners know well and can trust.
• We get asked a lot if there’s a future for wholesale mortgage originations. Surveys show that wholesale was a disaster last year:  Tiny margins + a disproportionate share of fraud.  It’s a crummy business, but perhaps once everyone has left it, the margins will increase due to simple supply and demand.  Also, once the credit cycle turns, perhaps some larger players will decide to use their excess capacity to go build their loan volume through wholesale.  But one would think that a FNMA/FHA world would be less amenable to wholesale, a commodity product where the middleman is not quite so important, and perhaps that’s what’s happening already with margins.
  Were we in the business today, we’d have an ROI hurdle rate, and if the wholesale division couldn’t meet it, we’d get out of that business. Technology can push costs down to help meet that ROI goal, but the price knowledge on FNMA products is too great to squeeze out much incremental margin, but we do have clients who are making it work.   They’re not making a fortune in wholesale, but they’re operating in the black.

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Let’s talk about risk for a moment.   Hedging interest rate risk wasn’t a big part of mortgage banking till the late 70’s. FNMA had some free puts – some even going out a year! – and there just wasn’t that much volatility. When rates went from 9% to 19% within a few short years, interest rate risk became a huge concern, and hedging went from secondary marketing people having a feel for rates to Paul Tuttle’s development of a model based on rational pricing of risk.  The Tuttle system created a number of offshoots over the years, and people who want to avoid interest rate risk now have the tools to do so.

But 2007 brought about something relatively foreign to mortgage bankers, this thing called credit risk. A sold loan was no longer off your books forever. Loans went bad and investors made mortgage bankers buy them back. Did anyone hedge against that risk?  There aren’t many tools, but one could have shorted the ABX Index of Sub-Prime Mortgage Securities, and losses from buybacks could have been offset from the gains on the short position. 

Or what about interest rate risk in the second order?  By this, we don’t mean risk in your pipeline of locks. We mean that if rates go up, your volume (and revenues) will probably go down.  So maybe you want to hedge a bit of this 2^nd order risk as well.

Without getting too detailed, options and futures are very simple at their core.   Companies in all industries take on risk that may exceed what they can handle or wish to handle.  By selling options and futures, they are simply removing risk from their own company and selling it to someone, usually a speculator, who is willing to pay to try and make money from his perception of that risk.

What we are calling for is easier said than done, but we’d like the industry to spend more time thinking about the risk it has, and the ways it can hedge (i.e. sell) that risk. There are a lot of smart people in this business, and there are many smart people on Wall Street.  At a minimum, we’d like to see more exploration on the topic.  Maybe it’s time to hedge more than just interest rate risk.

Joe Garrett and Corky Watts  -  Garrett, Watts & Co.