Someone asked us yesterday what this mess with Bear Stearns (NYSE: BSC) is really all about, in plain language. Good question. We replied with a question, "Did you ever make a soda fountain suicide?"
"Huh?"
"A soda fountain suicide. That's when you take a cup to a soda machine and put a little of everything in the mix. A little Cherry Coke here, a little Fanta there, perhaps some root beer, some Sprite, really whatever is available. You get a thick, syrupy mix-up that doesn't really taste like anything, and doesn't taste very good either."
"Right."
"Well, a lot of the collateralised debt obligations (CDOs) and collateralised mortgage obligations (CMOs) are like suicides... only the financial kind. A firm like Bear Stearns mixes together thousands of different mortgage loans or commercial leases. It puts them all in the same package and slaps a yield on it. Presto! A wide variety of disparate credit products suddenly becomes an asset you can buy and sell like a stock."
"So what's the problem?"
"The problem is that with a suicide it's only four or five different kind of sodas, and most of the time you end up throwing it out anyway because it's no good. Bear Stearns, on the other hand, can't just throw it the millions in CDOs and CMOs it has on its balance sheet. It's mixed them altogether and it's hard to untangle them and separate the bad credit risks from the good ones. So the whole thing is marked down in value."
"Why did anyone think a financial suicide was valuable in the first place?"
"Good question, to which there is no obvious answer. Think of it as an institutional attempt to launder credit risk."
"Huh?"
"It's like this. A bank makes a loan. But instead of keeping the loan on its books as an asset, it sells the loan. This frees the bank up to make another loan. And because interest rates are cheap, the bank loans a lot. And there seem to be plenty of buyers for the loans the bank has made. Because of this, the bank stops paying attention to who it's lending to. After all, it's going to sell the loan anyway, so it doesn't have to worry about whether the loan is ever repaid, right?"
"Right."
"But someone has to worry about the quality of all those loans and leases. Wall Street figured it could reduce the risk of all those individual loan decisions and asset valuations by packaging them up...and that the credit quality of whole would be worth more than the sum of the parts. It's not true really. And that's why it's risk laundering. But it's useful for the people who sell those packaged loans to believe that it's true. And so they do."
"So what does that mean now?"
"It's still useful for the people who buy and sell those packaged loans to believe they are worth than the sum of the parts. The trouble is, nobody else believes it any more. Why? Well, in America, a lot of people borrowed a couple of hundred thousand dollars to buy a house. Many of these people are starting to realise the mortgage is more, or may soon be more, than what they can actually sell the house for."
"How does that work?"
"Not very well. But mechanically speaking, here's what happens. Let's say the median price of a house is $250,000 and the loan-to-value ratio was 95%. The buyer puts up about $13k upfront and borrows the rest of the purchase price. Then, home prices start falling - as they are now all over America. The borrower is paying more in monthly mortgage payments than he'd receive in rent. And he's not getting too many tax breaks from it, either. But mostly, he's now realised that house prices don't always go up."
"That sounds like a bad deal. Don't house prices always go up, at least for the long haul?"
"No. It's useful for people to believe so, especially real estate agents and home builders. But as financial assets, houses are just like any other kind of asset. Prices move in cycles. Buy at the top of the cycle and you're in for a hard go."
And on and on it went. You get the point. The worst part of America's mortgage lending bubble is that it managed to straddle two asset markets at one time, real estate and equities. Most people will survive a bad real estate decision by renting and coming back in the next cycle for a new shot at home ownership.
But this housing bubble managed to migrate, like a clever virus, to the share market through the mortgage-backed securities market. There are dozens of other pension funds, insurance companies, and god knows who else than own mortgage backed bonds. It's a lot of dirty laundry. And the airing has just begun.
Dan Denning
The Daily Reckoning Australia
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About the Author
Dan Denning is the author of 2005's best-selling The Bull Hunter (John Wiley & Sons). He began his financial publishing career in 1997 and has covered financial markets form Baltimore, Paris, London and, beginning in 2005 Melbourne. He’s the editor of The Daily Reckoning Australia and the Publisher of Port Phillip Publishing.
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[...] one-year anniversary of the beginning of the subprime crisis. A year ago this week we covered the slow-motion collapse of two Bear Stearns funds, the High Grade Structured Credit Strategies Enhanced Leverage Fund and the High Grade Structured [...]