``The demise of two Bear Stearns managed Leveraged Mortgage Funds could be the tipping point of a broader fallout from subprime mortgage credit deterioration that would lead to cascading de-leveraging and ultimately ending with higher rates to new mortgage borrowers,'' New York-based analysts at Bank of America Corp. including Robert Lacoursiere wrote in a report published today.
Let's translate this sentence.
Mortgage securities 101: Loan originators sell the vast majority of their mortgage loans to firms that securitize loans. This means that securities firms take similar mortgages (same coupon, length to maturity etc...) and place them in giant pools of mortgages. By giant, we're talking $10 million minimum and usually quite a bit larger.
This pooling of assets is assumed to diversify the risk. Suppose there is a pool of $100 million mortgages. Out of this pool of $100 million, there is one loan worth $100,000 that is delinquent. Because this $100,000 loan is so small in relation to the $50 million pool (it is .01%), this one loan's underperformance won't effect the overall performance of the entire pool.
However, let's say there are 10, $100,000 loans that are delinquent. Now about 1% of the entire pool of mortgages are underperforming. This means we could start to have a problem with the entire pool of mortgages.
There is no universal point at which an amount of underperforming loans automatically impact the performance of the overall pool of mortgages. Each mortgage pool is unique onto itself.
Let's extrapolate this information to the bigger picture.
Delinquencies are increasing. As a result, there are more loans in mortgage pools that are underperforming. That means a larger number of mortgage pools may be experiencing problems. This is what the paragraph is talking about. The possibility that the number of underperforming/delinquent loans is starting to impact the entire industry is increasing. Bond 101: increasing risk = increasing interest rates. If someone is going to lend a high credit risk borrower money, the lender will ask for more interest as compensation for the increased risk.
2 comments:
bonddad, I'm usually against alarm, but this is potentially huge. Per the following:
http://archives1.sifma.org/story.asp?id=2793
The Securities Industry and Financial Markets Association today reported that 2006 U.S. bond issuance increased to $6.13 trillion, the second highest volume ever, from $5.71 trillion issued in 2005. Corporate bond issuance, at a record-setting $1.05 trillion, increased close to 40 percent from year-ago levels, and issuance of asset-backed securities also set a new record for the year....
Global CDO issuance in 2006 nearly doubled from 2005 levels to $488.6 billion.
[prior aggregate global CDO issuance totalled USD 157 billion in 2004, USD 249 billion in 2005]
So let's say there is $1T of CDOs out there. How much leverage has been employed on these obligations by hedge funds and others?
After the faillure of the Bear Sterns fund, especially where Merrill only (was able to?) auctioned off $100m of the $850m they seized, what is the aggregate "market value" of CDOs today? Who had CDOs at 90% leverage and is now in fact wiped out? Apparently they "mark to model" rather than "mark to market". Question: Do they have to "mark to market" now? Or do they continue to play "See no evil" in which case pension funds like CalPERS might be receiving account balances that are total fiction?
This could be a blip. It could make LTCM in 1998 look like a picnic.
BTW, remember how we speculated about Bill Gross' comments several weeks ago. Do you suppose he knew that a big player (or players) were in trouble, and decided to give them a push? Maybe PIMCO was short long treasuries, or was looking to create a buying opportunity?
Slightly off topic, but perhaps the rules of the game have already changed and the current supreme court decisions are of the "closing the barn door" variety.
It seems to me the two biggest changes have been the creation of opaque financial instruments and the rise of private equity funds. Both seek to escape from government (or any other) scrutiny.
I think we may now be in the end game. When the public is finally let onto the ball field the real teams have already left. The biggest indicator is the sudden flurry of IPO's from hedge funds. The argument that they need to sell shares to raise capital doesn't seem to hold up - their business model is based upon borrowing funds. It looks more like them cashing out now that the days of big earnings are drawing to a close.
The large number of opaque financial instruments seems also to be running into trouble. The current issue with Bear Stearns and several other mortgage re-packagers highlights the difficulty of those who have done business with them. When they wish to unwind their investments it is almost impossible to figure out who owns what and where the ultimate liability rests. Firms should become more leery of getting involved in the future because of this.
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