Annotated article summary from this weekend's Barron's. Receive all our Barron's summaries by signing up here:
Garbage In, Carnage Out by Jonathan R. Laing
Summary: Interest rates on $800 billion in subprime loans will reset in 2007-2009, further endangering residential mortgage-backed securities. Originally constructed with premium AAA mortgage bonds on top, 'mezzanine' collateralized debt obligations in the middle, and high-risk, high-interest BBB and BBB- bonds on bottom, debt-rating agencies like Moody's and S&P then sugar-coated mezzanine CDOs by rating 80% of them AAA, assuming geographical loan diversification and varying 'slices' of debt values would protect the structure. Torrential-growth CDO² (BBB-only securities), twice removed from the loan collateral, are teetering -- just 5% in loan losses could render them worthless. Moody's forecasts 2006 subprime mortgage losses of between 6%-8%; some foresee 10%. After Bear Stearns (NYSE:BSC), and UK's Caliber Global Investment subprime trouble, Canada's CIBC now admits it owns $330 million of subprime securities. Debt insurers Ambac (ABK) and MBIA (NYSE:MBI) own almost $1b and $800m respectively. Unlike the $150b U.S. Savings & Loan bailout, subprime infection is global: German state banks, Asian investment houses, hedge funds and Wall Street firms are among subprime holders. Now debt-backed takeovers are losing investor appeal, and the ABX subprime index has lost almost 50% since January. Investors will likely pursue debt-rating agencies for misleading ratings. Barron's says subprime losses could surpass $100b.