SocraticGadfly: Subprime loans: why they should be a serious economic concern

March 20, 2007

Subprime loans: why they should be a serious economic concern

Pension funds could be up shit creek, that’s why

These subprime loans became financial “instruments,” then were rated by Moody’s and other folks trading on mutual back-scratching, is why. It’s just like at the start of this decade, when folks like people at Merrill Lynch were touting certain stocks in exchange for “considerations” from the relevant companies.

As Kevin Drum says:
Fortune notes that a big factor in the recent success of the subprime lending market has been the ability to repackage subprime loans into clever little bundles of asset-backed securities that are then traded on the open market. But there’s more. An even bigger factor is the fact that these debt instruments (called collateralized debt obligations, or CDOs) have generally received investment grade ratings even if the mortgages underlying them were highly risky.

Sniff those class-action lawsuits getting even bigger?

Wait. Here’s more from the actual Fortune story:
To appreciate the role that the rating agencies play in today’s housing market, you have to understand a piece of Wall Street alchemy: the process by which mortgages are combined, carved up, recombined and carved up again in almost endless permutations to create new forms of debt (which usually go by three-letter abbreviations).

A bank or brokerage bundles up hundreds of mortgages and sells investors debt that is backed by mortgage payments and secured with homes. These asset-backed securities — ABS’s, in Street parlance - are sold in slices, each of which carries its own theoretical level of risk, ranging from the supposedly invulnerable (AAA) all the way down to the bottom rung of investment grade and even past that, to a highly speculative unrated slice.

It's possible to create a AAA-rated asset out of somewhat shaky collateral, because the first dollar of income goes to the securities with the highest rating, while the first dollar of loss is assigned to those with the lowest. The bottom layers provide a cushion that supposedly protects the higher-rated securities.

Lately much of the bottom rung of investment-grade ABS’s has been snapped up by another Street creation called a collateralized debt obligation (CDO), which, like an ABS, is sold in slices. A large chunk of a CDO that consists of barely investment-grade securities can still secure a coveted AAA rating — again, because any losses have to eat through the bottom layers.

In other words, subprime loans are a big Ponzi scheme, to put it less politely. No wonder we get zero-down balloon-note mortgages. And it’s no wonder cookie-cutter homebuilders build crap, if they’re building for a Ponzi scheme.
These products exploded in popularity in recent years because investors — including pension funds and insurance companies, which must mostly buy investment-grade-rated debt — had a voracious appetite for them. That in turn encouraged a historic increase in subprime lending.

So, if these subprime loans ever WERE to be rated at below investment grade, a bunch of pension funds could be up shit creek, along with insurers, mutual funds, etc.

How potent has this nectar of financial temptation been?
The amount of subprime mortgages issued shot up from $35 billion in 1994 to $625 billion in 2005, says Josh Rosner, a managing director at research firm Graham Fisher. Brokerage firms, which packaged, sold and traded these creative instruments, made big
profits. And so did the credit-rating agencies.

At Moody’s (the only one publicly traded), net income went from $159 million in 2000 to $705 million in 2006, in large part because of increases in fees from “structured finance,” the umbrella under which this mortgage alchemy falls.

WOW.

NOTE THAT: A 2,000 percent increase in subprime loans in a decade. Moody’s has an almost five-fold earnings increase in just six years. Anybody with a brain knows there HAS TO BE envelope-pushing (to put it mildly) wheeling-dealing, swap-outs, quid pro quos with stuff like that. And, the small mutual fund investor, etc., will probably wind up holding a large share of the bag.

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