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If
you’re like me and can’t seem to get your arms around
the concept of home loans pooled into mortgage-backed
bonds packaged into collateralized debt obligations (CDOs)
carved up into tranches combined to form other CDOs (CDOs-squared),
you may wonder what all the hullabaloo has been about
these past few weeks.
Unless
you’re a Bear Stearns Cos. stockholder or an investor in
a hedge fund that owns the riskiest piece of a CDO (the
equity tranche), the owners of which line up behind
everyone else when it comes time to get paid, why should
you care about complex Wall Street structured-finance
products designed to turn a hefty profit without landing
the issuer in jail?
Answer:
Because losses in one area have a way of rippling
through to others; because risk is a four-letter word,
especially if priced improperly; because uncertainty
about the value of illiquid, opaque securities backed by
home loans breeds risk aversion on the part of mortgage
lender and CDO investor alike; because the lightly
regulated derivatives market has become so big and so
diffuse that some out-of-nowhere event may bring the
domino theory back for a retest; and because each of us,
directly or indirectly, owns a small piece of the rock.
When he
was Federal Reserve chairman, Alan Greenspan extolled
derivatives as a way to unbundle and transfer risk to
those willing to assume and manage it.
But
first the risk has to be identified and priced as such.
Many CDOs were considered practically risk-free, with
their ability to deliver a steady, reliable return month
after month.
Safety
in numbers
It’s
true there’s safety in numbers. Put enough junk bonds or
subprime mortgages into a composite entity, and a
default here or there isn’t going to matter.
It may
be easy, with the benefit of hindsight, to say “there
was insufficient capital at the very beginning, but it
was not impossible to determine it at the closing date
based on the underwriting characteristics of the loans,”
says Sylvain Raynes, a principle at R&R Consulting, a
structured valuation boutique in New York, and author,
with Ann Rutledge, of “The Analysis of Structured
Securities.”
The
delinquency rate for subprime loans rose to 13.8 percent
in the first quarter, according to the Mortgage Bankers
Association. It was 11.5 percent a year earlier.
When the
collateral in residential mortgage bonds is impaired,
“nothing will undo the losses,” says Joseph R. Mason,
associate professor of finance at Drexel University in
Philadelphia. “It’s a static pool of investments, a
brain-dead trust.”
Buying
time
With the
residential real estate market continuing to
deteriorate, mortgage-related derivatives aren’t only a
concern for sophisticated investors, rating companies
and regulators. Subprime delinquencies may cause
problems for everyone from potential homebuyers to small
investors to the Federal Reserve to the man on the
street. It’s something everyone should care about.
If you
are a Bear Stearns shareholder, you should care. The
securities firm will inject about $1.6 billion into one
of its failing hedge funds to prevent a fire sale of
illiquid assets, including CDOs, by creditors. The stock
has lost $6.46, or 4.4 percent, since the announcement.
In
becoming its own lender of last resort, Bear Stearns
bought itself some time. If neither housing nor market
conditions improve, time may not be on its side.
Hedge
funds should care. The over-the-counter CDO market is
opaque. The value of any CDO is primarily
model-determined. There is no active market and no fair
market value. It’s a kind of don’t-ask-don’t-tell-’til-you-gotta-sell
system.
Making a
mark
Once a
CDO is sold, it forces other investors to revalue, or
mark to market, that security. Last week, creditors of
Bear Stearns’s hedge funds seized collateral to cover
the funds’ losses and ended up selling only a small
portion of the assets. It’s not far-fetched to think
other lenders to other hedge funds will come a knockin’,
forcing liquidations into a poor market.
The
small investor, who may have no idea what a CDO is,
should care.
“We
should care because our money market account, pension
account, insurance company all may be invested in these
securities, which have not been tested in a down cycle,”
says Joshua Rosner, managing director at Graham Fisher &
Co., an independent financial-services research firm in
New York. “We should care because as we saw last week,
an asset carried at a value determined subjectively
maybe be worth a lot less when it’s traded.”
S&L
crisis
The
Federal Reserve should care. While Bear Stearns’s
bailout of its hedge funds is being compared to Wall
Street’s rescue of Long-Term Capital Management in 1998,
a better paradigm might be the savings and loan crisis
in the early 1990s. Insolvent thrifts saddled with—guess
what?—bad real estate loans depleted the now-defunct
Federal Savings and Loan Insurance Corp., which provided
deposit insurance to S&Ls. The US government created the
Resolution Trust Corp. to dispose of bad loans, auction
off the underlying properties, shut insolvent thrifts
and arrange for solvent institutions to assume the
performing loans of insolvent ones.
The
result was a true credit crunch, with banks unable to
make new loans until they repaired their balance sheets.
The economy hobbled along until the process was
complete.
Nowadays
banks are only a small part of the home-loan market.
Outside the banking system, the situation is worse.
Rising defaults on subprime mortgages have forced some
60 mortgage companies to close or sell their operations
since the start of 2006, according to Bloomberg data.
Prime
real estate
Lenders
are tightening credit standards on mortgages to
non-creditworthy borrowers at a time when the inventory
of unsold homes is at a record of 4.43 million. The
overhang has doubled in a little more than two years.
Potential homeowners should care. First-time buyers may
have greater difficulty getting a mortgage, which means
owners of starter homes may have trouble selling theirs,
and so on up the food chain.
The man
on the street should care. It gets tiresome reading
primers on structured finance on the front page day
after day when Paris Hilton is achieving new levels of
self-awareness. The sooner newspapers can get back to
what sells, the better.
Lastly,
your humble correspondent should and does care. My brain
is fried, my energy sapped, and my spirit depleted from
talking to structured-finance gurus. At my lowest point,
I even began to understand how an investor could buy
this stuff without asking the appropriate questions.
Caroline Baum, author of Just What I Said, is a
columnist for Bloomberg News. The opinions expressed are
her own. |
