Cramer's Meltdown Spills Into Print

by: Felix Salmon

There's a school of thought that Jim Cramer just plays a screaming nutcase on TV, that in reality he's actually quite smart and knows his onions.

On the other hand, he's also capable of using his column in New York magazine to write something like this:

This spring, as many homeowners stopped paying, the mortgage bonds—for the first time—starting losing value. Hundreds of billions in bonds that were thought to be worth more or less the price they were sold at, it turns out, are worthless.

Bonds are almost never worthless. Even in cases of enormous and outright fraud, like WorldCom, bonds aren't worthless. Cuba stopped paying its debt decades ago, and its bonds aren't worthless. And mortgage-backed bonds, of course, are backed by mortgages, which in turn are backed by houses. The minimum recovery value on a defaulted mortgage is about 50%.

And this isn't some kind of Cramer slip. He repeats himself later on, and even says that he's smarter than Bear Stearns' Warren Spector:

Spector, maybe one of the best minds in the bond business, genuinely believed that these mortgage-backed bonds still had substantial value. If someone as savvy as Spector thought these bonds were still good when they were actually worthless, that tells you that thousands of other managers are simply dreaming if they think their portfolios are worth anything near what they claim they’re worth.

The thing is, Spector was right when he saw a certain amount of value in mortgage-backed bonds. If Cramer really thinks that mortgage-backed bonds are worthless, he should be shorting them all like crazy right now. But I don't think he is. The AAA-rated tranche of the ABX subprime index has already started to rally in price – it's now back up to 92.5, from a low just below 90.

Now to be charitable to Cramer, it's possible for a mortgage-backed bond to be worthless even if the underlying mortgage still has value. The first-loss tranches in a waterfall structure can be wiped out entirely, leaving the value for the holders of the higher-rated bonds. Although it's worth noting that even the lowest, BBB- tranche of the ABX index is still trading in the high 30s: a long way yet from zero.

In any case, most of the losses at subprime-exposed hedge funds have not been due to holding low-rated tranches which might be wiped out; instead, they've been due to leveraged exposure to high-rated tranches which have merely dropped in value.

There are some very nasty things going on in the mortgage-backed market right now, so there's really no need for this kind of hyperbole. Cramer's meltdown has been something of a hit on YouTube, so maybe he's just trying to milk the last drops out of it. But he's wrong about housing, and he's wrong about the value of mortgage-backed bonds, as well.