Problems with Subprime loans (loans made for too much money against too little collateral to people with too little sense and too many other bills to pay) again dominated this weekend's Barron's reporting. In "Just How Sub Is Subprime," Jacqueline Doherty details just how many folks on Wall Street had a hand in the Subprime mess, as mortgage brokers shovel this financial manure into the Wall Street product engine where it is sold, repackaged, and re-sold (just) before the first month's payment is ever missed.
Brokers purchased subprime loans by the millions, which local mortgage "bankers" dutiful sold to U.S. consumers desperate for a plasma screen TV and a new house to put it in. The brokers then dump these IOU's into a separate trust so that when they go bad, they won't imperil the brokers own bonus pool. The trusts are then carved up into separate "tranches," some of which are more likely to get paid back, hopefully with interest, than others. The most likely tranches to actually pay off as advertised get a high ("AAA") rating, while more speculative pools receive lower ratings. These tranches can be sold directly to big mutual funds or pension fund investors, but the stuff that is particularly toxic was best suited to be placed in yet a separate bankruptcy remote entity, so-named not because of the remote chance of bankruptcy, but again to protect the hard earned equity of the broker promoting this scheme. The recipient of the multiple tranches of toxic subprime IOU paper is called a Collateralized Debt Obligation (or CDO), which is often funded on money borrowed from honest folks who usually don't charge a lot of interest. This creates a "spread" for the CDO manager, usually some other Wall Street maven, who buys a bunch of high yielding toxic crap using honest money that doesn't pay very much and for a time, as long as the boom lasts, everyone is happy.
Wall Street is happy because it charges a pretty penny, paid up front in cash, for packaging this financial nightmare. The CDO managers are happy because they are leveraged up the wazoo and control billions of dollars of assets, if only for a time, on which they can suck out as much as 1% annually to pay for their new flat overlooking Central Park. The borrowers are happy because they got to see Grey's Anatomy on a TV the size of their grandma's washing machine, and the lenders are happy as long as the economy is robust and the borrower's can afford to pay this month's mortgage.
When the borrower's can no longer afford to pay because, for example, the artificially low 2002 interest rates adjust upward, as might have been anticipated by anyone with a brain sized larger than an ant's, the entire financial "package" begins to unravel. The "overcollateralization" which is supposed to protect the lenders is compromised because loans to deadbeats really aren't worth 100 cents on the dollar. If this economy tips into recession, the problems worsen. Suddenly, some of those tranches are no longer money good, though it's tough to know which right away, and the bankers and hedgies who lent money to the CDO's in order to buy the toxic financial crap want their money back, which seriously inconveniences the investors who had to cut short their ski trip to Aspen in order to begin reading the fine print in the offering statements of the subprime loan agreements.
Naturally, Wall Street (the packager of this toxic crap), who knows what sort of manure is spread throughout the traunches, is one of the few players in a position to offer liquidity to the now distressed subprime lending industry, and Wall Street always stands ready to offer liquidity - at a price. It's a little early to know just how big a haircut the major on-their-way-to-bankruptcy subprime lenders will have to accept. But the same loans that Wall Street once packaged and repacked for $1.00 (less their fees, of course) are likely to receive bids somewhere in the range of 60 - 75 cents on the dollar, if the sellers are lucky. Unfortunately, the subprime industry is very leveraged, meaning that there really isn't 25 - 40 cents of equity for every loan out there, meaning that even non "subprime" lenders are exposed, because anyone who made a loan to New Century or one of several other now bankrupt lenders is also exposed. Not badly exposed, but bank earnings at even the high quality institutions are going to feel a pinch.
Doherty points out that the subprime lending industry is not a "cottage industry." It's big business, and the major Wall Street firms and hedge funds have had a direct hand in packaging this garbage, and now in bidding on the dredge that it created. How can Goldman Sachs afford to pay out annual bonuses of roughly $722,000 per employee? How does Blackstone Group justify a $40 billion price tag to shareholders (when the lions share of its winnings are sure to find their way into the hands of employees)? Because Wall Street gets investors coming and going.
Yet investors continue to delude themselves into thinking that the investment bankers at Goldman and Merrill and Smith Barney, et. al., are their side! These bankers are only loyal to the annual bonus pool, and don't really care which side of the fleecing will generate their fees.
They packaged and repackaged internet companies and IPO'd ideas on a napkin for billions of dollars in market capitalization that vanished overnight. Then, five years later, they packaged the real estate bubble for pension fund investors, who are the primary supporters of the hedge fund excesses, and now we'll watch them switch sides to become bidders, at cents on the dollar, of the financial garbage they manufactured just a few years earlier.
It's a replay of the junk bond debacle and the Resolution Trust Company "solution." And it's probably the second oldest profession, albeit less upstanding by far. No doubt, White House Chief of Staff, Joshua Bolten, New Jersey Governor Jon Corzine, U. S. Treasury Secretary Henry Paulsen, Clinton Treasury Secretary Robert Rubin, and former New York Fed Chairman John Whitehead will want to ensure that such shenanigans never happen again - except that they all came up through the Goldman Sachs grist mill, and aren't likely to bite the hand that once fed them.
At least we know who to thank for the pain we are about to feel.
Douglas B. May, CFA, is President of
May-Investments, LLC and author of
Investment Heresies.
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