I'm not sure if submerging prime is a threat to the economy, but the explanations for why the economy would keep on sailing with nary a worry over the imploding, submerging mortgage market, were always just a little too neat, and tidy for me.
Here is a round-up of some of the submerging prime articles that have appeared over the past month.
First, Barry Ritholz postulated on how the submerging prime market could unravel.
Next, markit, is a great site to track collapsing prices in the CDO market.
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According to a recent Bloomberg article, CDOs masked the problems in submerging prime, and the ratings agencies are partly to blame for this mess.
When it comes to CDOs, rating companies actually do much more than evaluate them and give them letter grades. The raters play an integral role in putting the CDOs together in the first place.
Banks and other financial firms typically create CDOs by wrapping together 100 or more bonds and other securities, including debt investments backed by home loans.
Credit rating companies help the financial firms divide the CDOs into sections known as tranches, each of which gets a separate grade, says Charles Calomiris, the Henry Kaufman professor of financial institutions at Columbia University in New York.
Credit raters participate in every level of packaging a CDO, says Calomiris, who has worked as a consultant for Bank of America Corp., Citigroup Inc., UBS AG and other major banks. The rating companies tell CDO assemblers how to squeeze the most profit out of the CDO by maximizing the size of the tranches with the highest ratings, he says.
"It's important to understand that unlike in the corporate bond market, in the securitization market, the rating agencies run the show,'' he says. "This is not a passive process of rating corporate debt. This is a financial engineering business.'' ...
In times of uncertainty, CDO ratings take on even less meaning, says Brian McManus, head of CDO research at Charlotte, North Carolina-based Wachovia Corp. Investors may not know what hit them because there won't be a sudden CDO crash, he predicts.
"They don't blow up,'' McManus says of CDOs. "They just kind of melt.'' ... Financial regulators have effectively outsourced the monitoring of CDOs to the rating companies. No less an authority than the U.S. Office of the Comptroller of the Currency, which regulates banks, depends on the rating firms to assess the quality of CDOs.
U.S. banks have invested as much as 10 percent of their assets in CDOs, and the OCC requires that all of those CDOs be investment grade, says Kathryn Dick, deputy comptroller for credit and market risk. "We rely on the rating agencies to provide a rating,'' she says.
CDOs have been a bonanza for the rating companies. In the past three years, S&P, Moody's and Fitch have made more money from evaluating structured finance - which includes CDOs and asset- backed securities - than from rating anything else, including corporate or municipal bonds, according to their financial reports.
The companies charge as much as three times more to rate CDOs than to analyze bonds, published cost listings show. The companies say these fees are higher because CDOs are so complex compared with a single bond. ...
Because there are so many moving parts to a CDO, rating companies have to assess not only the chance that something may go wrong with one piece but also the possibility that multiple combinations of things could falter. To do that, S&P, Moody's and Fitch use a mathematical technique called Monte Carlo simulation, named after the Mediterranean gambling city.
The rating companies take all the data they have on a CDO, such as information about specific bonds and securitizations and the remaining types of loans to be purchased for the package.
The firm enters data into a software program, which calculates the probability that a CDO's assets will default in hypothetical situations of financial and commercial stress. The program effectively rolls the dice more than 100,000 times by running the information randomly.
The rating companies base their simulations and ratings of each tranche on assumptions about default and recovery rates that may be incorrect, Cifuentes says.
"The danger with Monte Carlo is that it gives you a false sense of security,'' he says. "If the input data that you use is a little bit uncertain, your numbers are going to be trash, but they will look convincing.''
Credit rating companies may have miscalculated the potential toxicity of securities backed by subprime loans, McManus says. "With CDOs, they underestimated the volatility of the subprime asset class in determining how much leverage was OK,'' he says.
The rating firms use irrelevant or incomplete data to calculate the probability, or so-called correlation risk, that various assets in a CDO will default at the same time, Das says.
"The models are fine,'' he says. "But they have an input problem. It becomes a number we pluck out of the air. They could be wrong, and the ratings could be misleading. I'm not even sure we understand the networks of links between the subprime tranches.''
Bank of America believes that what we have seen in submerging market is merely, the tip of the iceberg.
Losses in the U.S. mortgage market may be the "tip of the iceberg'' as borrowers fail to keep up with rising payments on billions worth of adjustable-rate loans in coming months, Bank of America Corp. analysts said.
Homeowners with about $515 billion on adjustable-rate home loans will pay more this year, and another $680 billion worth of mortgages will reset next year, analysts led by Robert Lacoursiere wrote in a research note today. More than 70 percent of the total was granted to subprime borrowers, people with the riskiest credit records, they said.
"The large volume of subprime ARMs scheduled to reset at higher rates in '07 and '08 will pressure already-stretched borrowers,'' putting more loans into foreclosure, the Bank of America analysts wrote from New York. A collapse of the Bear Stearns funds "could be the tipping point of a broader fallout from subprime mortgage credit deterioration,'' they said.
And, for some strange reason, lenders are "surprised" at the speed of the bust.
The subprime mortgage meltdown has been a shock to industry insiders, but now they say it's hitting harder and faster than expected - even to those who predicted the crisis in the first place.
Why? It is very common, if not likely, for over-inflated asset markets - any asset market - to come down fast. Do these people not understand financial history?
Apparently not.
The recovery will "play out quicker than in the past," according to [David] Lowman, [chief executive of JPMorgan Chase & Co.'s global mortgage business] "because [the fall] happened faster than in the past."
Is he joking? Such a sharp rebound is highly unlikely. Global housing prices were in a bubble. Busts follow bubbles. They're not pretty, and they never "play out quickly." Did the Nasdaq come roaring back after its dramatic descent? No, of course not. I hope JP Morgan isn't betting the house on Mr. Lowman's outlook. Otherwise, I'd suggest you short JP Morgan stock.
Not surprisingly, according to Reuters, given the lax standards, most borrowers fudged their income on applications for submerging prime loans.
[Comptroller of the Currency John] Dugan cited a Mortgage Asset Research Institute study that found 90 percent of borrowers reported incomes higher than those found on file with the Internal Revenue Service and almost 60 percent of the stated incomes were exaggerated by more than 50 percent.
Another survey of more than 2,100 mortgage brokers, reported by Inside Mortgage Finance, found that 43 percent of mortgage brokers who use low-documentation loan products know their borrowers cannot qualify under standard debt-to-income ratios.
This ain't over. Not by a long shot.
