Garbage In, Carnage Out [Barrons 7.9.07]
By JONATHAN R. LAING
LOW INTEREST RATES AND LAX LENDING STANDARDS allowed millions of Americans to buy homes in the past few years, including many who lacked the means to repay their mountains of "subprime" debt. Now that mortgage rates are rising and the bill is coming due, these borrowers aren't the only folks who may be facing financial Armageddon.
Attention has begun to turn in recent weeks to the trillion dollars or so of securities Wall Street rolled out in the past two years to fund the mortgages of less-creditworthy borrowers, who are starting to default in higher numbers. The losses on these securities, which sit on the books of banks, brokerages and other financial firms, not only in the U.S. but around the world, eventually could exceed $100 billion.
How did the U.S. subprime-loan market morph into a ticking time bomb? The answer begins, and ends, with Wall Street's ingenuity, which was enhanced by something curiously close to alchemy. To raise the aforementioned trillion dollars to purchase the flood of new subprime mortgages from lenders, brokerage firms invented residential-mortgage-backed securities, or MBS, which they sold to institutional investors. These securities consisted of different slices, or tranches, of bonds, with triple-A and other highly rated tranches having repayment priority as the original borrowers paid back principal and interest.
Investors at the lower reaches of the waterfall -- that is, the triple-B and triple-B-minus tranches -- earned much higher interest rates on their debt to compensate for the considerably greater risks residing in these securities. If the mortgage pool underlying an MBS were to suffer a principal loss of just 7% from defaults and foreclosures, some MBS experts calculate, these tranches would be cut off from the pool's capital flows and rendered worthless.
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To facilitate the sale of the higher-risk tranches, and arguably gin up more fees, Wall Street repackaged many triple-B mortgage-backed securities, and even more of the triple-B-minus tranches, into new securities called mezzanine collateralized debt obligations, or CDOs, which also were sold to institutional investors. "Mezzanine" referred to the difficult-to-sell securities that sat in the middle of the MBS capital structure, between the higher-rated securities at the top and the high-yielding, equity-like tranches at the bottom. The latter were much-coveted by speculators.
It is at the mezzanine level that the so-called alchemy occurred, when bond-rating agencies such as Moody's and Standard & Poor's rated some 80% of the principal amount of the triple-B tranches as triple-A. Under the "grade inflation" that came to be accepted in subprime-CDO land, the top 60% of the mezzanine capital structure was called "super-senior" triple-A.
As one dealer in MBS told Barron's, "Mezzanine subprime CDOs are all the same junk." But because one slice of the CDOs was subordinated to the rest, the rating agencies allowed most of these highly speculative securities "to be turned into gold."
Barron's was unable to reach structured-finance rating experts at either S&P or Moody's late last week, though a Moody's spokesman referred us to a March 23 report that detailed several "mitigating factors" likely to protect mezzanine subprime CDOs from catastrophe. For example, the report stated, many such CDOs combine tranches from other structured-finance sectors such as securities backed by commercial mortgages and other commercial loans, as well as credit-card and auto-loan asset-based securities. Where sector diversification was insufficient, Moody's said, it would insist on the credit enhancement of additional subordination below triple-A and greater excess spreads between the interest-rate yield on the underlying loans and the yield paid to investors.
THE PAST TWO YEARS also has seen explosive growth in mezzanine CDO-squared, or CDOs constructed from the lower slices of existing CDOs, and thus twice removed from the underlying MBS collateral. Some 80% of these structures likewise boast triple-A ratings, even though some industry insiders say the value of the instruments would be wiped out, from the triple-A tranches on down, if the underlying collateral suffered cumulative losses of around 5%.
Such subprime-mortgage losses are more than theoretical, or "notional," these days. Since January, the ABX index that measures the performance of triple-B subprime MBS tranches has lost nearly half of its value. Credit downgrades of mortgage-backed securities are just starting to rise.
In a recent report, Moody's revealed that 3% of the subprime mortgages securitized in last year's third quarter are now in foreclosure. It projected that because of unfavorable trends in home prices, mortgage rates and lending standards, cumulative losses on loans backing 2006 subprime securitizations will "generally range between 6% and 8%." Some market participants see even higher losses, of 10% or more, in last year's securitizations, not to mention trouble with the 2005 "vintage."
 was forced to bail out, to the tune of $1.6 billion, an internally managed hedge fund invested in subprime CDOs. A British investment fund, Caliber Global Investment, said it would shut down because of heavy losses in subprime paper issued in 2005. And margin calls on subprime-CDO collateral put the mid-sized California broker-dealer Brookstreet Securities out of business.<br><br>Subprime-CDO woes also have altered the market's perception of risks related to other sorts of securitizations, including those collateralized by high-yield corporate debt and bank loans, causing tremors in the takeover market. Investor resistance led U.S. Foodservice to trim a $3.6 billion bond and debt deal two weeks ago to help finance its buyout by two private-equity firms. A number of high-yield bond deals were also yanked.<br><br>Mezzanine subprime exposure is showing up in all sorts of surprising places. The Canadian bank CIBC has acknowledged ownership of around $330 million, though some observers say the figure could be more than $2 billion. That estimate would constitute a substantial chunk of the bank's approximately $13 billion in shareholder equity.<br><br>The bond and structured-finance insurer Ambac has 'fessed up to guarantee exposure of $980 million of subprime mezz CDOs, and MBIA (MBI) to $800 million. Financial institutions in Japan and Korea have been buyers, along with the state banks in Germany. Many hedge funds are loaded with the paper. And much of this potentially hazardous waste likely sits in the investment accounts and proprietary-trading accounts of the Wall Street firms that originally securitized the CDOs, lending new meaning to the notion of eating one's own cooking.<br><br>Few, if any writedowns have occurred yet to the value of such CDOs, as holders are able to mark their positions to model, rather than market. That's because few mezzanine CDOs trade in the secondary a market. Ignorance, in this case, truly may be bliss.<br><br>Once the downgrades and impairment charges begin, the rating agencies could find themselves in an uncomfortable position. "I would expect a lot of holders of these CDOs to sue the credit companies for handing out triple-A ratings to paper that turns out to be toxic waste," says the head of bond trading at a New York hedge fund that has been bearish on subprime debt.<br><br>MORTGAGES HAVE BEEN securitized for years, severing the umbilical cord that once tied bank and S&L lenders to borrowers. As a result, lenders have had diminished interest in careful underwriting of loans, and borrowers have had little contact with the originators of their mortgages as the loans disappeared into pools of thousands of similar mortgages. The impersonality of the process made loan modifications difficult when personal or business problems arose. Still, any mortgages sold off to investors generally had to "conform" to certain standards laid down by government- sponsored enterprises like Fannie Mae and Freddie Mac to receive their all-important guarantees.<br><br>In the mid-1990s, however, lenders began to reach out to new home buyers and borrowers who didn't qualify for traditional mortgages, either because they lacked the resources to put down 10% or 20% of the purchase price of a house, or failed to meet long-inviolate debt-to-income and net-worth standards. Increasingly mortgage brokers, often operating from store fronts, replaced traditional financial institutions as mortgage originators.<br><br>Wall Street grew more involved in the process by either by financing the mortgage originators with warehouse lines of credit or even purchasing them outright. This insured a steady flow of new subprime loans that could be securitized and sold to investors.<br><br>The rating agencies became crucial players as lending standards loosened and securities structures became more baroque. Buyers increasingly bought the subprime securities based purely on credit ratings and spread, having neither the sophistication nor time to do their own research.<br><br>Moral hazard virtually disappeared from the subprime arena as players from the originators to the rating agencies earned their fees up front. Those fees could be added to the principal balance of a loan once the subprime-mortgage market breached the 95% loan-to-value ratio on its way to LTVs of 100% or more.<br><br>The process was almost riskless for the producers and securitizers, as the loans moved down the production line at the lightning pace of four to five inventory turns a year. Mortgages typically don't go bad until they've "seasoned" for a couple of years following securitization. By then, investors would be stuck with any problems.<br><br>Besides, delinquencies and defaults seemed to cure themselves, particularly during the housing market's bubble years, between 2001 and 2005. Borrowers who paid in little or no equity generally could sell their homes at a sufficient profit to cover any outstanding debt. Subprime had become a perpetual-motion machine.<br><br>Last year, however, several disturbing developments occurred. Inventories of unsold new and existing homes began to build. Home prices stopped going up and even started falling in many of the subprime meccas like California, Arizona and Florida. As a result, many subprime borrowers, who could be counted on to refinance once their two-year teaser rates were about to reset, stopped showing up. They had either refinanced during the 2005 refi boom, or run out of equity.<br><br>To feed the beast, the subprime industry had to go even more down-market in 2006, until it was scraping the bottom of the barrel of potential borrowers. Loan terms were further debauched. Annual income and net-worth information was either ignored or embellished. Loans as percentage of values, which often were based on phony appraisals, blasted through 100%.<br><br>The Bottom Line<br>Banks, brokerages and hedge funds that have been eager buyers of subprime CDOs could face losses of more than $100 billion in coming years.<br><br>Speculators loved 100% margin loans on houses; they had nothing to lose. If prices went up, they would score big profits. In a weak market they could stop paying on their mortgages and live rent-free for six months or more while the foreclosure process dragged on. The money they saved on mortgage payments could be used as security deposits to rent a new home or apartment.<br><br>Early payment defaults surged, often in the first month or two on many of last year's subprime mortgages. More than 60 subprime originators, such as New Century Financial, went out of business in late 2006 and early 2007 because mortgages with early-payment defaults were put back to them by Wall Street securitizers. Then the Wall Street firms would administer the coup de grace by pulling their warehouse credit lines from the same originators.<br><br>FAR GREATER TROUBLES await the subprime market in the next two years, when homeowners will face increases of as much as 50% in their monthly payments after their two-year teaser rates expire and convert to materially higher floating interest rates. The period will see some $800 billion in subprime loans reset, according to Deutsche Bank.<br><br>For many subprime borrowers, default will be the only viable option, as tighter lending standards slam the refinancing window shut for them. Dwindling or negative equity in homes means they won't be able to roll into 30-year fixed mortgages, even assuming that they handle the higher monthly payments. Foreclosures are expected to surge.<br><br>It is becoming increasingly obvious that the credit-rating agencies made some fundamental mistakes in according triple-A status to so much subprime-CDO debt. Their models assumed the U.S. housing market is regional, not national. Therefore, they reasoned, large CDO pools, composed of mortgage slices from all over the U.S., would provide sufficient diversification to withstand localized meltdowns.<br><br>Yet subprime problems appear to be metastasizing. Sloppy loan underwriting in the past two years and the looming reset problem are national in scope. And many subprime CDOs are synthetic creations that reference the performance of the same mortgage-backed tranches.<br><br>The coming crisis in subprime CDOs is reminiscent of the S&L collapse of the early 1990s; both involved imprudent lending and will be enormously costly. The bill for the earlier fiasco totaled more than $150 billion.<br><br>This time around the burden will fall on global investors, not the U.S. taxpayer. But the repercussions are apt to be felt on Main Street as well as Wall.</span></td></tr></table></div></tr></td><tr><td colspan=99 class=) |
