Monday, April 11, 2011

Subprime Mortgage Bonds Making a Comeback?

On April 1, 2011, the Wall Street Journal reported that subprime mortgage loan bonds are “back in vogue with long-term investors.” In what apparently was not an April Fool’s Day joke or spoof, the Wall Street Journal detailed how subprime mortgage loan bonds, perhaps the primary progenitor of the recent financial market crisis, are attracting investors anew based on the greater risk that these bonds allow investors to assume.

The WSJ portrayed this reemergence of subprime mortgage loan bond investment as a sign of economic recovery and a kind of healing of the credit markets, rather than as an ominous sign that investors and Wall Street banks refuse to learn lessons from past failures. The article reports that this renewed investment interest in ultra risky vehicles, like subprime loan bonds, “underscores how investors have regained the courage to take on more risk as the economy recovers.” Subprime loan bonds are securities that are backed by hundreds or even thousands of loans to homeowners with spotty credit histories.

What is motivating this renewed interest in extraordinarily risky subprime bonds? The WSJ credits higher subprime bond yields due to the Federal Reserve’s policy of pushing rates of return down on more conservative investments. Even large life insurance companies, like bailout poster child AIG, are jumping back into the subprime bond investment arena. An executive at bailed out J.P Morgan sounds intoxicated with excitement: “Getting an opportunity to look at a portfolio like this in the secondary market is exciting and appealing.” The Fed also noted a “high level of interest by investors” on these dangerous subprime bond products.

A voracious appetite for subprime loan investment instruments drove mortgage lenders in the early part of this century to create ridiculous loans to satisfy investor appetite – loans that lenders admitted were “toxic” and “poisonous.” This news feels like déjà vu all over again.

Despite what feels to me like an alarming development, a Senior VP at Moody’s claims that we are not “back to the old days.” Did this Moody's credit rating agency executive (still with financial market crisis blood on his hands) mean to say, we are not “back to the old days, yet”? As detailed repeatedly in this blog space, Dodd-Frank and other recent legislation does little to protect against history repeating itself on the subprime loan investment front.

11 comments:

  1. Frankly, this development isn't that much of a surprise to me. In fact, it is actually a logical outgrowth of the government's approach to the financial market collapse. When financial firms aren't compelled to bear the risk of all their risky ventures (i.e. when massive government subsidies are the corrective to the failure of high risk investments) there is little reason to stop. This is a textbook example of the “moral hazard” problem. See http://www.npr.org/templates/story/story.php?storyId=16734629. Like a rebellious teenager whose father consistently bails him out of trouble, the financial firms who are re-entering this market are blind to the consequences of their actions. As long as they are allowed to continue making these high-risk investments with impunity, it is entirely possible that another financial collapse is inevitable. Thus, while I do not profess to come anywhere close to understanding the intricacies of the Dodd-Frank legislation, it is clear to me that something needs to be done to either massively disincentivize (or even outright prohibit) these “toxic” investments.

    Michael Stark

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  2. It seems to me, as seen in other contexts, the corporate realm is simply continuing its historical practice of recklessness and greed. See andre douglas pond cummings, "Procuring 'Justice'?: Citizens United, Caperton, and Partisan Judicial Elections," 95 Iowa L. Rev. Bull. 89 (2010). In accord with the apparent lack of regulation provided by Frank-Dodd (I, too, have little knowledge regarding this legislation), the Citizens United case augments the government's practice of protecting and supporting corporate dominance and freedom. However, at what point do we learn from our mistakes, and work diligently to correct them?

    Admittedly, I would submit that there must be a balance on both ends of the spectrum. There is an absence of "lesson-learning" on the borrowing side as well, if borrowers are willing to continue living outside their means by assuming debt beyond their paychecks. Could there not be a middle ground where responsibility, self control, and (at the risk of sounding naively utopian) a general regard for the welfare of others all meet at a compromise between the lenders, investors, and borrowers?

    Bus. Org.
    Andrew F.

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  3. The comment that was made that stood out the most to me was the one questioning whether we are not "back to the old days, yet." I too agree that it seems logical that firms would go back to these risky investments because of the bailouts that were given in the past. Until the government and the firms prove the differences in the new risky investments, I think that we all have to be in fear of another crash in the area of subprime mortgage loans.
    -Shana O
    Bus. Orgs.

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  4. As a believer in free-markets, I think these firms should have the freedom to take on the risk/reward level they think will generate the most profit for their shareholders. If that means taking on highly risky bundles of mortgages, so be it. Finance gurus have crunched the numbers and calculated the potential profits at specified risk levels. Many times, the firm will diversify adequately so that overall a substantial profit will be made.

    However, should these risky investments fail, the wall street firms should bear the same consequence that an individual investor bears when making a poor investment decision: crash and burn. The government should not step in and remove drastic consequences. As Stark alluded above, the only way an investor can truly learn from a mistake is by bearing the consequences of the decision, whether it be high profits from smart diversification or bankruptcy resulting from greedy investments.

    -S. Andrew Stonestreet

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  5. The economic climate in the United States has suffered significantly because of the high risk investments that failed and have not been corrected. I think that there are two important questions we must ask: 1) How do we prevent another buildup of toxic assets; and 2) How do we handle the left over toxic assets. Obviously, companies will continue to work with subprime mortgage loan bonds as long the potential reward outweighs the risk. The subprime mortgage loan bonds/securities backed by hundreds or thousands of unstable loans, in an already unstable economy, is not going to produce a different result unless the impossible happens and all of the loans are paid. The problem appears to be who bears the risk and who controls the market. Large investment companies control the market and are able to avoid risk Also, I assume, as toxic assets go without being purchased their prices drop and the temptation to work with subprime mortgage loan bonds increases.
    I think we need a plan that spreads the risk, rather than consolidating these assets in mortgage loan bonds, and give the actual loan holders terms that will stabilize the market. For instance, if the payoff periods for loans are doubled the debtor will be able to make the smaller payments, the mortgagee will have steady payments, and the market can slowly and naturally readjust. We could also place regulations on the amount of loans used to back subprime mortgage loan bonds, but this will have little effect. On the other hand, something must be done with all of the outstanding toxic debt, and companies are going to jump at the chance to make huge profits with little risk. I am not sure of the solution, aside from prohibiting these risky securities, but allowing companies to engage in behavior that caused a collapse in the economy should not be rewarded via corporate bailouts. The large bailouts did not make sense, and it would have made more sense to bailout "main street" and stabilize the underlying loans and teach companies like AIG a lesson.

    John S

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  6. At its heart, the subprime mortgage problem depended on people who could not at all afford homes purchasing them anyway, whether because they deluded themselves about their financial situation or were deluded by banks and the real estate industry, and were then subsequently able to obtain easy financing. If subprime mortgage-backed securities are making a comeback with investors, I would be curious to know if the financial crisis has altered consumers' behavior in any way. Are people still buying houses they can't afford? Has the doom and gloom in the housing market, rampant stories of underwater mortgages and borrowers trapped in bad deals by banks made consumers more cautious about stepping into the housing market? I would find it hard to believe that people haven't altered their behavior at least somewhat in response to the financial crisis and continued high unemployment and uncertainty about our economy. If consumers' behavior has been changed, does that mean the subprime mortgage market isn't as quite as risky as it was prior to the crash? Is history really repeating itself (yet), or did the financial crisis at least alter the landscape in some way in this area?

    - Matt W. / UC

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  7. In February 2008, I predicted the stock market crash. I didn’t have a crystal ball, I am not a soothsayer, all I did was know history and read the signs. Oversimplified, the crash of 1929 occurred as a result of over leverage. In 2008, the market was overleveraged again. The first indication of this problem was the Auction Rate Market Failure. Briefly, auction rate securities have specified periods of maturity 7, 28, or 35 days. At the maturity date, the securities are available for purchase. If there are not enough buyers in the auction, then a market failure occurs and the securities will reset to a “default” rate. Prior to 2008, there hadn’t been a failure since the 1990s, because large investment firms would purchase the remaining securities if a failure loomed. In February 2008, the auction failed because the investment firms were overleveraged as a result of their involvement in the subprime market.

    A few months later, the world witnessed a stock market crash that rivaled the crash of 1929. Many scared long term investors sold out of the market and went to cash. Recently, these same investors have started to creep back into the market. Hopefully properly reallocating their portfolios which most likely include a portion of risky investments. Risky investments include sub prime mortgage bonds. Yes, these risky investments are the same investments that caused the 2008 collapse. However, it must be stated that the DANGER in risky investments come with EXCESSIVE use in a portfolio. (Excessive use depends on the investor’s overall risk tolerance.)

    The investing adage, “the greater the risk, the greater the return” applies here. As the article stated, “[t]he attraction of bonds underpinned by subprime home mortgages is fat yields.” The article illustrates this point, “[t]hese securities yielded close to 20% during the downturn, and are now fetching between 5% and 7%—still well above roughly 3.5% yields on U.S government bonds and 4% on high-quality corporate bonds.”

    Therefore, “back in vogue with long-term investors” simply means that investors are trying to reenter the market and regain their footing in the wild, wild west of the stock market. Are sub prime mortgage bonds making a comeback? Sure they are. They probably should be. Will investors learn from history and keep their investments in risky investments, minimal? That remains to be seen.

    Courtney R.

    Bis org.

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  8. As a homeowner with difficulty and struggling. I am extremely delighted for this news. I am hoping I can get teamed up with a lender to start in a better financail situation and recover my credit.

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  9. Subprime loan investor must understand the risk they have taken. With my only opinion the mortgage crisis collapsed are some what reason why because of the greed, financial creativeness and wrongful collateral report. The subprime should remain an aletnative from the "A" paper fall out only with backed with collateral equity security, proper income stability and credit mid risk borrower. If subprime has remain as the traditional back in 1998 - 1999 the mortgage crisis will not be as devastated as it is now. I'm sure the stock market experts and financial expert will agree. Subprime mortgage should have remain as it was with full documents program, 90% loan to value secure collateral and with reasonable credit history risk providing homeowner with reasonable rate for 30 years fix the mortgage would not have been as disaster as it started on early 2007. This secured collateral should be sellable to other intities not only among subprime investor. There are times the "A" paper investor has purhase subprime borrower with low risk base on income stability, equity on collateral, mid credit risk with reasonable debts and reserves. By bringing back the subprime it will help the economy with cautions. It will create some employment and opportunity to some what recovery from economic crisis. Once again this is only my perosnal opinion.

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  10. mortgagecloser101@yahoo.comMay 8, 2011 at 1:46 PM

    I believe to get the economy back on track subprime needs to make a come back there needs to be some guidelines in tact. I worked in subprime for over 10 years and I enjoyed both companies I worked for. Option One had integrity and was a wonder Company. New Century was the other company. I believe that with the struggling economy we need subprime back to not only to help balance out the crisis but for consumers to get into better financial shape. Loan mods are fine but that is only handling the mortgage part. I think we need to look at the individual information and think outside the box on some of the loans. Consumers may not have scores above 500 range that doesn't mean that if they were in a different situation where all debt was included with maybe an arm for 2 to 3 years to get their credit in tack to reach a score of possibly in the 620 range. Ir may take some of the investors a risk but it could possibly turn the economy back around afterall isn't everything a risk nothing is ever certain.

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  11. If that means taking on highly risky bundles of mortgages, so be it. I am extremely delighted for this news. Great post.

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