Features > July 17, 2007

Tranche Warfare

Who will be left holding the bag as subprime mortgages go bad?

By Dave Mulcahey

Now that the real estate bubble seems poised to go the way of its dot-com predecessor, a new narrative has taken hold in the business press. Where once reporters breathlessly touted double-digit, year-on-year gains in home prices, they now warn darkly of the “meltdown” underway in the class of exotic mortgages that added so much punch to the party.

After months of dismal reports for the real estate industry—declining sales, rising inventories, softening prices, rising foreclosure rates—the news took a sharp turn for the worse in late June, when the investment bank Bear Stearns shut down two hedge funds whose holdings were laden with securities backed by subprime mortgages.

Suddenly, finance pundits and insiders were speculating about just how far the damage of bad subprime loans would spread. Could it be “contained”? Were more hedge funds on the verge of implosion? Was the debacle about to touch off a system-wide credit crunch?

Meanwhile, a bemused public was wondering what the rarefied world of hedge funds had to do a bunch of poor suckers who had bought more house than they could afford. How many of these loans could there be—and how many defaults—that a Wall Street powerhouse like Bear Stearns was taking it on the chops? And what’s the story behind all these subprime loans, anyway? Whose idea was all that funky lending?

The insiders’ questions have yet to be answered. But for financial naifs, the Bear Stearns imbroglio was highly instructive. It briefly pulled back the curtain to reveal the machinations behind the mountain of mortgage debt the American peasantry has piled up during the great housing bubble. Subprime lending in the United States rose from $35 billion annually in 1994 to $625 billion in 2005. A shocking proportion of this financing was extended on the flimsiest pretenses of due diligence by lenders, and carried terms and conditions sure to ruin a large number of borrowers. According to Fannie Mae, between $1.1 and $2.2 trillion in adjustable-rate mortgages will reset to higher rates in 2007. Another $1.4 to $2.4 trillion will reset in 2008—half of it subprime and another quarter less than prime. It’s difficult to see how that will end well. Yet for a while, the bubble seemed like some millennial, never-ending win-win scenario.

By now it should be apparent to most Americans that we’re beyond the George Bailey model of mortgage lending, in which banks and other mortgage lenders hold on to the loans they write. Most mortgage paper nowadays is instantly sold, and the buyers are the big Wall Street investment banks, which repackage it as mortgage-backed securities and various “structured finance” products (such as the gizmo that got Bear Stearns into trouble, the “collateralized debt obligation” or CDO). The point of “securitizing” home loans is easy enough to understand: It takes an illiquid obligation—Joe Doaks’ mortgage—and, by pooling it with similar debt, transforms it into a fungible, liquid security that can be rated for creditworthiness and sold to institutional investors.

Many institutional investors, such as pension funds, mutual funds, insurance companies and so forth, are restricted from buying debt unless it’s investment-grade—that is, debt with a rating of BBB or better (the rating expresses default risk, not value). And here is where the genius of structured-finance products like CDOs comes into play. These securities can pool quite unsavory debt—subprime mortgages, for example—and repackage it in ways so that at least some of it will be suitable for the more choosy investors mentioned above.

They do this by dividing the pool into segments, called tranches. The senior tranche might carry the highest rating (AAA), while the “mezzanine” tranche carries AA to BBB. The lowest segment, the so-called equity tranche, is typically unrated. Again, the entire pool might be made up of shaky loans — downright dodgy ones, in fact — but the senior tranche may still merit the AAA rating because it always claims priority of payment. It gets the first dollar of cash flow, while the lowest tranche takes the first dollar of loss. Because most borrowers—even subprime ones—pay their mortgages, money managers can buy AAA tranches with a relative degree of confidence.

Theoretically, that is. But more about that in a moment.

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• Reader Comments

  A lot of people have been burned in this scam — the home purchaser (if he had a down payment), some of the resellers, the investors in mortgage companies and hedge funds — in short those directly connected.

  The fallout will spread to those who will now have an even more difficult time qualifying for a loan due to the tightening of lending practices form those who “got religion” (until the next time).

  A long time, very good friend had to be moved into a assisted living facility nearly two years ago. He had been unable to do home maintenance for about a decade and his kids sold the homestead to a rehab guy to get the funds needed to care for Dad.

  About a year ago I stopped by and talked with the rehabber and tour the house — all new carpeting, a new kitchen and two baths, all windows replaced, trees trimmed — a total of $45,000 in replacement and repairs.
  The home across the street was vacant and he was thinking of sending a bid to the bank.

  That home repossession should have (may have) been a warning to him. It is still vacant and no work in progress.

  My friend’s house did not sell and has now been rented. Out of eight houses I regularly pass in our neighborhood, two have been for sale for more than a year, two have been taken off the market for a time and are now back on, two now have sold signs (well, sale pending).

  This is a typical 40-year-old middle class neighborhood of homes in the 1700k to 2500k square foot range. There are several deteriorating, uninhabited houses which only get the grass mowed about once a month. No money down means they can walk away.

  Perhaps the last ditch money source — credit cards — can carry this “(consumer driven) Goldilocks Economy” a while longer, but with the prices on energy and food (those often excluded CPI items) continuing to soar I wouldn’t count on it.

  Only those who know when to fold ‘em made out on this.

  First the dot.com fiasco and now this — They thank you, Maestro Greenspan.

  Posted by whattheheck on Jul 17, 2007 at 6:50 AM

  CORRECTION:  1700 to 2500 sq ft (Bill Gates doesn’t live near here.)

  Posted by whattheheck on Jul 17, 2007 at 8:01 AM

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Also by Dave Mulcahey

• Tranche Warfare
  Who will be left holding the bag as subprime mortgages go bad?
• Hooray for Hookergate!
  
• Passion of the Right
  The uses of persecution
• Another World, Possibly
  
• The Wise Many
  
• Design Flaw