sub-prime meltdown

Nice infographic from the NY Times on the mortgage industry that highlights one-half of the current mortgage / sub-prime meltdown.

There are two things to understand in this industry. First, banks used to underwrite mortgages but now investment banks and investors implicitly do it. A bank takes in deposits from its customers and this cash would be used to forward a loan to a mortgage customer so they can buy a house. Now what happens is the big investment houses like Goldman Sachs buy these loans off the banks and package them into investment vehicles. Both MBSs (mortgage backed securities) and CDOs (collateralized debt obligations) are really just a portfolio of various types of mortgages and other loans types. Investors then buy a piece of these portfolios much like they buy a piece of a company (shares). The big problem here is that the people underwriting the mortgages (the banks) no longer have a direct incentive to assess the risk of a mortgage accurately. The mortgage is sold off to someone else. Who cares if a home buyer can't pay his mortgage bill 3 years from now? The bank doesn't own it.

Second, the ratings that are placed on the CDOs and MBSs that help investors figure out how much to pay for them are done by ratings agencies like Moody's. Who pays Moody's? Goldman Sachs. See the conflict of interest? Goldman wants to sell these securitized debt products off at a high price. If Moody's doesn't give them a good rating, Goldman could decide to go somewhere else to get the rating done.

The second piece of this puzzle is who is buying these products and how do they make money? Lots of institutions. Hedge funds, pension funds, etc. Because subprime mortgages pay a higher interest rate on average, the owners of these securitized products earn a larger rate compared to other debt products. A hedge fund might have $1B under management and get a return on securitized debt products of 6.5% let's say. That's not going to make their clients happy. So they go out and borrow a lot of money. Let's say $10B or $20B at 4.5% and get a return of 6.5% on the MBS. Or in other words 2.5% on $10B. Now the fund is making 25% returns. Now the clients are happy. This is leverage. And for a while the leverage seemed low risk. The ratings agencies were saying these 'traunches' of MBSs were AAA rated and home prices were increasing so home owners could refinance their mortgages rather than default. Since the clients are happy they give you more money and you lever up even more.

Well that's not happening anymore. Refinancing is not an option and so sub-prime borrowers are defaulting. At a higher rate than expected for these traunches of securitized debt. Someone blinks. The bank loaning the $10B to the hedge fund wants more collateral. It's wants the hedge fund to pony up more cash. The only way to do this is to sell some of the securitized debt. But if the market for the debt isn't there (because no one wants them anymore) then they can only be sold at a loss. So they have to sell more securitized debt to reach their collateral requirements. But these sales reveal the true value of the debt in the rest of the hedge fund's portfolio. The value of the remaining debt is revalued (or 'marked') meaning the hedge fund has less collateral. The bank loaning the $10B realizes this and asks for more collateral. You can see where this is going. This is the unravelling the papers are talking about. No one really knows where it stops.