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.

More on Fannie and Freddie

As detailed on this blog, last week the Federal Housing Finance Agency (“FHFA”) released the first of what will be quarterly status reports of the financial health and condition of the mortgage giants Fannie Mae and Freddie Mac. The report provides a revealing snapshot of the companies, and its conclusions challenge many commonly-held assumptions about the reasons the quasi-governmental agencies nearly failed.

A handful of economists, hundreds of politicians, and thousands of citizens place entire blame for the financial crisis on the two mortgage giants, in particular for creating and later bursting the housing bubble that nearly collapsed the global economy. Wrong. The Report shows that Fannie and Freddie’s market share plunged in 2003 and at the peak of the dangerous subprime mortgage and mortgage backed securities markets, Fannie and Freddie’s combined total share was only 1/3 of the mortgage market. Fannie and Freddie are not blameless, in that they clearly dipped their toes in the subprime market mania most notably in 2005 and 2006. Still, the report makes clear that private investment banks drove the appetite for subprime mortgages, the mortgage backed securities market and the collapse.