A Guide to Subprime Terms and Possible Solutions

There are many exotic terms for new investment vehicles, derivatives and the like floating around. Not all are very well understood or explained by the general press.

New to me are terms like tranches, collaterlized debt obligation, (CDOs, which are made up of just about any type of loans backed by something that has some intrinsic value), [X] Mortgage Backed Securities, and [X] MBS, where X is either commercial or residential. Then there are ETFs and CEFs and trusts and what have you.

The CDOs that everyone is talking about right now are essentially bonds, whose assets are a pool of income generating instruments, like mortgages, credit card receivables, bank loans or even rights to popular or classic songs and music. These assets are lumped together and handed over to a trustee who collects the monies coming in and after expenses redistributes them to the bondholders.

If one or more of the individual assets defaults, there is still usually enough income from the other performing assets to maintain the integrity of the entire instrument. The problem only comes to the surface when a significant number of little defaults occur that impacts the actual pay out, after Trustee expenses of course.

About the trustees, it should be noted that for these instruments there are usually a fairly large number of trustees. There is a trustee for the bond. There are trustees for the various pieces of the bond that make up its ingredients. For example, a mortgage backed security is made up of, say, 1000 mortgages. These mortgages may not be from a single source. They may be from, say, 10 different banks or institutions. The creator of the bond buys these mortgages from these sources at slightly below face value. The provider retains the rights to service the individual mortgages, collect the monthly payments and hold an escrow account for insurance and taxes. The mortgagee calls this person when there are problems relating to their loans. The monies collected are then made available to the bond trustee, after the individual loan trustee takes out their expenses.

Since there is still money coming to the bond trustee for these instruments, from the various parts that make it up, everybody could still get some money but less. To resolve this dilemma the creators of these investments broke up the pool into what they called tranches. These are essentially slices of a single pie, all made with the same ingredients. The upper triple A level tranche would always get a full, SMALL slice of the pie, but the lower levels might only get to smell the pie should things go wrong, though initially they had been getting the BIGGEST slices.

All in all, on the surface this seems like a really good idea. And for a short while everything was going well until Brother Murphy stepped into the picture and reaffirmed his law.

The problems we are seeing now are multiple:

1. The number of defaults is rising and may even escalate should the economy go into a recession.

2. In the beginnings, the mortgage provider guaranteed that their mortgages would last at least a certain amount of time before defaulting. When a number of these mortgages did begin to default early the purchasers of those mortgages took advantage of their put and had the mortgage companies buy back those pools. Many of those mortgage companies are gone or just about wiped out. There is some evidence that fraud was involved in the mortgage application process and the FBI is investigating per some reports I have read.

3. Defaulted loans, that are already included in debt obligations, can not be easily processed through the court system, as there is no clear evidence of who actually owns the loan. In the case of mortgages the asset may be claimed by a number of different tranches. There are even CDOs that are made up of multiple CDOs. If everybody owns it then no one owns it, seems to be the way the courts are handling this.

4. The bonds are long-term instruments that were meant to be held to maturity, but were financed with short-term borrowing. This worked as long as general interest rates were very low and Commercial Paper dealers were more than willing to accept asset backed commercial paper issued by SIVs and hedge funds that were willing to pay higher yields for the cash. But, as interest rates rose and investors locked in higher yields elsewhere, the excessive liquidity everyone blamed for the Low long-term rates seemed to dry up. The commercial paper markets now had less cash to spread around and began to take a closer look at what was being put up as collateral for their cash.

5. When the holders of these bonds, a hedge fund or a SIV, went to the money markets to refinance their short-term loans the money markets wanted more interest and more collateral or they would not refinance these loans. So the hedge fund or SIV (Structured Investment Vehicle) had to sell the Bond to pay back the commercial paper market. (I am using money market and commercial paper market interchangeably here.)

6. When the hedge fund tried to sell the bond the potential buyers wanted a price quote but there was no real-time pricing on these instruments. They may have checked around and found no one willing to buy it from them at face value or even at a reasonable discount.

7. When Merrill seized the assets of Bear, it was revealed that the emperor really had no clothes on and everything went to hell in a hand-basket from there.

8. As more and more fire sales of these Bonds took place, and the approach of new accounting rules, banks began to write down their holdings of these instruments.

9. Now the federal government has lead the way to the voiding of contractual obligations by forcing the banks to freeze the rates on adjustable rate mortgages. This may seem like a little thing right now but then so is the first couple of weeks of being a little bit pregnant.

Are there solutions for this situation? I think there is but it is a very expensive one and far too late for the investors of those hedge funds and SIVs that went belly up.

The federal Government should buy all of the existing bonds, which then gives them rights to the underlying securities. The securities will then need to be identified and segregated by state of origin. Those securities should then be distributed to the owning state in lieu of federal revenue sharing and allow the individual states to do with the local assets, as they deem fit. If the States want to forgive the loans that is up to them, if they instead want to collect rent from the resident that is their business as well. They would eventually have seized the property anyway for non-payment of property taxes.

This solution would revitalize the lending institutions as it would take all these non-performing assets off their books and rebuild their working capital.

Some may quibble about bailing out hedge funds or the wealthy or even giving windfall profits to the undeserving. If this is done quickly the transactions will be short-term capital gains for the recent buyers and they will need to pay the taxes on their gains. The alternatives of trying to let things work out at their own pace might lead to a replay of the situation in Japan and that is unacceptable.

If I got anything wrong, please feel free to leave me comments. These "things" are new and there is much about them that is still unknown. Just ask Moody's, Fitch or S&P.

Disclosure: none

Comments

[Naysayer:]

The players will take their lumps and it won't last nearly as long as Japan debacle,no bailouts for errors in judgement,please.

2007 Dec 31 10:17 AM

[348s:]

The proposed solution is a wacky and naive budget-buster.

2007 Dec 31 11:41 PM

[Myron Shlapak:]

Naysayer, the US Depression lasted over 10 years and only ended by substantial Government spending during WW II. We already have a World War going on in Iraq and Afghanistan. If you don't think so just look at all of the Nations involved in the fighting

Sksqia, the idea may be wacky but not more so than the abrogation of valid contracts outside of the bankruptcy courts.

And as far as a budget buster, what budget? We went from a surplus to a deficit in two years, or less. But enough of politics.

I suggested that the monies used be the funds that are allocated for Revenue Sharing with the States. This is money already in the Budget, when it gets approved

2008 Jan 01 05:57 AM

[mbc3216:]

The federal govt cannot force the acceptance by the creditors of a lesser rate of interest. We are a nation of contracts. When the govt can force the change in a commercial contract, they are weakening the the very pilars which have made this country so great.

2008 Jan 01 06:05 PM