What is all the fuss about...I mean what is it really about?

I've posted twice on problems in the subprime mortgage market here and here.  For those of you who were bored to tears reading those last two posts on the subprime mortgage market, well, time get out the Kleenex again.

As I wrote in my previous posts, the wholesale lenders (companies like New Century or Countrywide) who provide the money to subprime borrowers do not actually use their own money.  Instead, they obtain large credit lines (sometimes on the order of several hundred million dollars) from commercial banks and also from Wall Street banks.  These credit lines are used to fund the subprime loans made directly to the borrowers.  The loans sit on the credit line of the wholesale lender for a month or two until the lender has enough loans to aggregate into a large pool.  These pooled loans are then sold to Wall Street investment banks who slice and dice them into bonds and sell the bonds to investors.  Actually, it's not just subprime wholesalers who work this way, but all mortgage wholesalers.  This includes those who make so called conforming loans (loans to those with perfect credit, lots of equity in their home and good jobs) and Alt-A loans (those with perfect credit, but may be self-employed and cannot document income).  

The loans are sold several times on their way to the ultimate bond buyers but the borrowers who originally took the loans only think it was sold maybe once.  What really happens is that all of the subsequent buyers of the loans hire a company to service the loans to the borrowers.  These servicing companies are the ones who send out the monthly statements to the borrowers, collect the payments, handle foreclosures and short sales, etc.

How is wall street actually slicing and dicing the loans into bonds?  What are the ultimate investors actually buying?  A recent innovation in debt financing is what has allowed so many new subprime mortgages to be offered and ultimately sold to bond investors.  What the Wall Street banks did was they realized that they could divide up the large pools of loans in such a way that they could spread the risk around to the various investors.  They sliced up the loans in what are called tranches (tranche is the French word for slice).  The top tranche bore the smallest risk and the bottom tranche bore the biggest risk.  If any of the loans defualted then any lost principal (the original amount lent to subprime borrowers) was borne by the last tranche (the riskiest tranche).  To compensate the riskiest tranche for the risk, they were paid outsized interest rates (sometimes as high as 15% or 20%).  For many investors, this high interest rate proved irresistible.  Especially due to the fact that foreclosures were historically low for many years.

The top tranche paid the least amount of interest but also had the least exposure to lost principal.  Because of the exposure of loss of principal was so low for the top tranche, the Wall Street banks  were able to obtain coveted AAA bond ratings from ratings agencies such as Moody's.

So who are these investors buying these various tranches?  Well, it depends.  Those who were buying the safest tranche were large institutional investors like the California Pension Fund, or the Harvard Endowment.  Those buying the riskiest tranche were typically hedge funds looking for extremely high returns.  However, ironically many of these hedge funds took investments from large institutional investors who usually have some portion of their funds under management earmarked for riskier investments that offer higher returns.  The hedge funds would take principal investments from investors.  Then using this as a sort of security deposit (much like a down payment on a house loan) they would arrange loans from Wall Street Banks and investors on favorable terms.  They would use these loans to buy the various tranches of mortgage bonds.  The difference between what they paid their lenders and what they received in interest payments on their mortgage bonds was called the positive carry. 

This is good business if you can get it.  You are taking money from investors, using this money as a down payment to arrange financing from banks at one rate and then re-lending that money at a higher rate by buying mortgage bonds.  The positive carry does not have to be very high for the hedge fund to show a large return on investment for its investors.  Remember, the original investment from the hedge fund investors is just a down payment for the hedge fund to arrange credit and loans from banks.  As an example, lets say you get $100 million investment in your hedge fund.  You use this as a down payment to arrange $1 Billion dollars in loans from large banks and investors at a favorable interest rate, say the 10 year treasury bond rate plus 4% (which would be about 8.8%).  You then use this money to buy mortgage bonds in the middle tranche that are returning 11% interest.  Your hedge fund is making the positive carry of 2.2% (the 11% you are getting minus the 8.8% you are paying).  This does not seem like such an amazing return, right?  But keep in mind that the original investors in the hedge fund invested only 10% of the value of the loans.  The difference of only 2.2% on $1 Billion dollars for one year is $22 million dollars.  Relative to the hedge fund investors' original investment of $100 million, this is a 22% annual return for the hedge fund investors.

Above was just an example to demonstrate how a hedge fund could make very attractive returns.  The actual numbers are often far larger.  As you probably all know, most hedge funds take 20% off the top of any profits earned by the fund.  These profits were so large that they enabled hedge fund managers to make huge money.  One hedge fund manager John Devaney made so much money that he bought a 142' yacht that he named Positive Carry.

Of course, all of this only works if the subprime bonds are performing (that is subprime borrowers are paying their payments and are not defaulting).  When the bonds default and the principal lent to the borrowers evaporates, then the lenders who lent the hedge fund money get very nervous and begin to freeze the credit lines and even demand repayment.  Also, the investors in the hedge fund also get very nervous and begin to make withdrawals from the hedge funds as soon as they can. 

The meltdown is caused because as subprime mortgages begin to default, it wipes out the principal investment by those investors who bought the riskiest tranche of mortgage bonds.  As these asset classes get wiped out, then the large pools of loans sitting on the credit lines of the subprime wholesalers (companies like New Century, or Countrywide) become unsaleable to the Wall Street banks.  Investors who are already getting killed by mortgage bonds they already bought are in no mood to buy even more of those same bonds from the Wall Street banks.  Those banks and institutions offering the credit lines to the wholesalers freak out and freeze all further credit to the wholesaler.  The wholesaler is then stuck and is not able to fund any new loans which essentially shuts down their business. 

This whole business depends upon subprime borrowers defaulting at a predictable rate.  When the rate of subprime defualts increases, the whole system begins to shut down starting with freezes on credit lines.  Credit lines to hedge funds are frozen so the hedge fund cannot borrower its way out of trouble.  Credit lines to wholesale lenders are also frozen so they can-not originate more loans to re-sell.

When I wrote before, this happened to New Century.  Well, since then it has happened to dozens of other lenders.  As a matter of fact, it happened to one of my favored lenders Aegis.  I had a loan that had closed and was ready to fund when the announcement came with no warning that Aegis had frozen all fundings.  What had happened is that Aegis' banks froze their credit lines.

The subprime woes are affecting even the largest Wall Street banks.  An example is the much publicised collapse of two Bear Stearns hedge funds.  These funds were actually conservative funds investing in the top (least risky) tranche of mortgage bonds.  However the investors in these hedge funds began to freak out and redeem money out of the fund.  The fund did not have enough liquidity to meet all the redemptions.

So what is going to happen?  I'm not sure, but I do know this:  A full 20% of mortgages in the US are subprime loans whose rates are set to adjust sometime in the next 2 years.  All of these loans are now in the form of bonds that are currently held by investors whether they be institutional investors, hedge funds that have not yet collapsed, and hedge funds that have collapsed and have had to have the mortgage bonds taken as collateral by the banks who offered the hedge funds credit.

All of these bonds have value but right now the value is unknown.  There is not a regular after market for these types of bonds and most holders of these bonds are afraid to sell them because they are afraid that the price they are offered for them will be so low that it will devalue the rest of the similar type bonds in their inventory.

I'll tell you what I would do if I had the resources, I would go to the investors who are freaking out and offer to buy their bonds for a song.  Then, as I said in my previous post on this subject, I would go to all of the borrowers in my portfolio who are more or less performing and I would unilaterally extend the fixed rate period on their loans until such time that they could refinance out of that loan. 

I believe that the vast majority of subprime borrowers do not want to lose their homes.  They want to keep them and they want to pay on time with their loans.  I would work with as many borrowers as possible to make their loans current.  I would freeze their interest rate so their payments would not increase and I would take any back interest that they owe and add it to the loan balance.  The most expensive thing for any investor is a a foreclosure.  I would make the foreclosure on these homes be my absolute last resort.

Somebody who did this I believe could make a killing in the mortgage market.  Heck, I could do it, I just need a few hundred billion dollars...anyone....anyone?

And what about the Yacht Positive Carry?  According to The Economist magazine....its for sale.