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Paulson Swipes Charlie Brown's Football

TCW's Jeffrey Gundlach on fallout from Paulson's TARP decision. (11/20/08)

Eric Jacobson: Hi, I'm Eric Jacobson; I'm a fixed-income specialist with Morningstar. We're in our studio today with Jeffrey Gundlach. He is the chief investment officer of TCW, and also the manager of TCW Total Return TGLMX.

I'm also here today with Larry Jones, the associate director of fund analysis, a specialist in fixed-income as well, talking to Jeffrey. Thank you both for joining us today.

Larry Jones: Thank you.

Eric Jacobson: So, Jeffrey, you've obviously given a lot of thought and talked quite a bit about what's been going on in the financial crisis. I know that not too long ago, you spoke publicly at a conference about sub-prime in particular.


You talked a lot and walked through sort of the valuation question. So, if I could just throw it over to you, help us understand a little bit your perspective in terms of the value proposition potentially or not thereof of what's out there today in the marketplace in terms of sub-prime residential mortgage-backed securities?

Jeffrey Gundlach: The values that are in the mortgage market, be it sub-prime, so called alt-a or prime, are all pretty compelling. It's really a problem of money being available against the downgrades that keep washing over these markets.

With every downgrade, fewer and fewer buyers are really eligible to buy these securities. There was relative stability versus corporate bonds, versus equities, versus emerging markets in non-agency mortgages of all stripes through October.

But just a several days ago, Henry Paulson came out and said, the TARP plan is no longer going to do what it was initially designed to do. Lucy took the football away from Charlie Brown, and instantly the values in the securitized markets collapsed.

In the two days following the Paulson announcement, the subprime index, the ABX, at the senior level dropped 20%. That really ushered in a collapse in commercial mortgage-backed securities that's been happening as well.

So, the values are there. The principal payback will be higher in all likelihood on any AAA rated security, one that started out at the top of the capital structure and where they are priced today.

But the problem is, the shrinkage of liquidity, the ongoing de-leveraging, the manage or redemption problem, is making it unlikely that prices will improve even in any kind of foreseeable horizon, which leads to the value proposition being based not just on some ultimate price value, but also on current cash flow.

This is where subprime falls down, because the AAA subprime, some of it pays LIBOR + 10, and it doesn't receive any principle, because it's locked out.

So, those investments may somewhere down the road prove to have high return ultimately, but as long as we are in this sort of bid-less market where you only have return of cash flow, subprime has a coupon of 1.5% on at the AAA level today, because LIBOR is low and falling.

That means that the cash flow is very poor. You're better off in fixed-rate securities, where the coupon is five or even six or even seven trading at a higher price, but also below recovery value, and throwing off cash flows in today's very distressed market as high as, believe it or not, 15% while you're waiting for maybe the recovery value to even be in access of your price.

So, lots of opportunity, but lots of illiquidity causing short-term gratification to be unlikely to happen on the price basis.

Eric Jacobson: So, when you talk about fixed rates in that context though, which part of the market are you referring to?

Jeffrey Gundlach: I'm talking about mostly prime mortgages or alt-a mortgages that are fixed rate. Subprime was a 228 program, fixed for two years, then the big shocking reset that everyone thought was such a surprise to them and caused people to feel like they were tricked.

Those resets have mostly occurred, but even so, they reset down to very low levels. When you put them into the AAA structure, the security pays a coupon that's LIBOR floating, some as low as LIBOR +7.

Because of the collapse in short-term interest rates, which in my view is not likely to change any time soon, very little interest cash flow, no principle cash flow in fixed-rate mortgages where there's not very many in subprime.

But in prime mortgages, the prices have also collapsed. It's amazing, but some of the better quality originations of prime mortgages, the types of things we own a lot of in the Total Return Bond Fund are down at prices in the 60s.

Now, the recovery rate on those, even in a depressionary outcome, should lead you to a price in the 90s, but you're going to wait a long time for that bid to improve against this environment.

They maybe downgraded, which could cause further shrinkage of liquidity, but at least in the meantime with a six coupon at a price in the 60s with some principal payback, because these are monthly amortizing mortgages, you are looking at very high cash-flow.

That's a key for investors to understand. The days of some quick turnaround on liquidity returning are not about to enter into the market. You need to be working on cash flow more, than on some price takeout at a higher level, at least for the first half really into 2009.

Eric Jacobson: Let me ask one more follow-up to that, which is, OK, so I think people probably can follow-up a good part of what you're saying, but there is a lot of fear that continued waves of default are going to decimate the market, what have you.

If I understand what you're saying, there is an analytical framework that I don't want to say that allows for that, but that assumes that there's probably going to be more defaults, but that you could still make money depending on the security, but something that's trading for example at 60.

If you could walk us through even just a simple example of how that might work.

Jeffrey Gundlach: Sure. Let's think about the--everyone keeps talking about the depression, so let's talk about that. In the 1930s, the mortgage market had accumulative default rate of something like 15%.

Now, these weren't securitized mortgages, because it didn't exist, but just mortgages in the banking community. They had accumulative rate a little under 15%.

If we say things are very bad right now, and prime mortgages by a good underwriter like a Wells Fargo, which is really the best underwriter based on performance in the industry--let's say 20% of them default. That sounds like a lot even versus the depression.

Let's say that when they do default, you only recover $0.50 against the loan because of this depressed real-estate market. That would mean 20% default, and you lose half of that. So, 10 points get lost.

Well, these AAA securities have 4% first loss subordination underneath them. So, of the 10 points that get lost under this 20% default case with 50% severity, you have four points of the 10 absorbed by the sub, six points would be the loss to the senior.

That would mean getting back around $0.94 on the dollar, a huge gain. If you really wanted to get pessimistic about the world and say 40% of them default, which is a horrific kind of cataclysmic economic event, still with 80% severity rate to get really extreme about how much you would lose with such a depressed housing market, you still would be returning back significantly more than the 60 that you paid.

So, it really is seemingly to be relative to those dynamics a no lose. How could it go wrong? Well, maybe all the loans get modified, and all the principal gets written down. That's an extreme position, but it's something that's bubbling through the market today.

Maybe all loans get refinanced, that would probably cause big principal payback, but there's ways that you could think about it, that maybe the income stream gets curtailed.

One of the problems that's facing investors now is, once the government started its programs, and we've seen all the different attempts being made and the bait and switch on the TARP plan. Knowing what the rules are going to be, going forward is getting more problematic.

That to me implies for people, back to basics approach is likely to envelop the thinking of investors. The mortgage market is a fairly back to basics place relative to some of the derivatives and synthetics and CDS and all the problems in the market, and ultimately should still be a place for people to gravitate.

But it is hard to know about the government programs regarding modifications and how that could affect things.

Eric Jacobson: Well, great, thank you very much for spending the time with us today. We appreciate it.

Jeffrey Gundlach: My pleasure.