The sub-slime that ate Wall Street

The SEC has launched a dozen investigations into the great mortgage mess of 2007. But there may be no stopping this train wreck

Published June 27, 2007 8:05PM (EDT)

On Tuesday, SEC chairman Christopher Cox told a House committee that the Security and Exchange Commission has launched a dozen formal inquiries into "complex bundled financial products" linked to the subprime lending sector and the recent collapse of two Bear-Stearns-managed hedge funds.

Of primary concern is the question of whether these "products" are being properly priced by their owners. Consider, for example, the hot topic of the day -- the subprime mortgage-backed "collateralized debt obligation" or CDO.

In an article published Wednesday noting that new issues of CDOs have plummeted in the last month, a Bloomberg News reporter defined CDOs as "pools of asset-backed securities, bonds or corporate loans divided into securities with different credit ratings and maturities to cater to investors' preferences." That can be tough jargon to get your head around. So just ignore it. All you need to know is that hedge funds and other investors, all over the world, own a bunch of subprime CDOs in their portfolios -- and that they are increasingly being lovingly referred to as "sub-slime" or "toxic waste."

There suddenly appears to be a good deal of worry that these complex financial instruments may not be worth exactly what everyone is pretending they are worth. To quote the perhaps overly colorful language of bond investment superstar Bill Gross, the founder and chief investment officer of Pimco, "Many of these good looking girls are not high-class assets worth 100 cents on the dollar." Investors were fooled "by the makeup, those six-inch hooker heels, and a 'tramp stamp.'" (Thanks to Nouriel Roubini for the pointer to Gross' entertaining rant.)

The crux of the problem: Mortgage-backed CDO securities aren't traded very often, so determining their true value is difficult at any given moment. But as long as everyone pretends together, no worries! If you want to know why Wall Street has been obsessed with the saga of two Bear-Stearns hedge funds for the past two weeks, there's your answer. When the reality that the Bear Sterns hedge funds were hemorrhaging cash became impossible to turn a blind eye to, a dreaded scenario began to emerge. In order to pay off anxious investors demanding their money back, Bear Stearns might have been forced to auction off all the assets owned by its hedge funds.

But that would have exposed the CDO Emperor's new clothes! A price tag would have been placed on sub-prime mortgage backed CDO securities, and the feeling on the Street is that it would have been a bargain basement number. That means that everyone else who owned such "financial products" would have to strongly consider revaluing their portfolios to reflect actual market conditions, rather than their own optimistic fantasies. (For minute-by-minute obsessive coverage of all things Bear-Stearns related, Naked Capitalism is your one-stop shop.)

The number one domino that would fall from any such revaluation on a large scale would be liquidity -- the access to cheap credit -- that keeps the wheels of the global financial system greased and rolling. All those private equity buyouts of publicly traded corporations that have been keeping the stock market rolling for the past few years depend on cheap access to finance to pull off their deals. Already, there are strong signs that the great buyout boom of the early 21st century is beginning to peter out.

A real credit crunch would be a very big deal. It might even be the "systemic shock" that critics of derivatives trading have been warning against for what feels like a generation.

How did this all happen? In a front page article today exploring how Wall Street was responsible for the vast increase in subprime lending that fueled the housing boom, the Wall Street Journal gives us the beginning of the story in a few nifty paragraphs.

A generation ago, housing finance was different. Bankers took in deposits, lent that money to home buyers and collected interest and principal until the mortgages were paid. Wall Street wasn't much involved.

Now it plays a central role. Wall Street firms provide working capital that allows thousands of mortgage firms to make loans. After lenders sign up consumers for home loans, investment banks pool the income streams from these loans into bonds known as mortgage-backed securities. The banks sell them to yield-hungry investors around the world.

Before the mid-1990s, mortgage-backed securities consisted mostly of loans to borrowers with good credit and cash to make ample down payments. Then investment banks found they could do the same with riskier loans to borrowers with modest incomes and flawed credit. Pooling the loans created a cushion against defaults by diversifying the risk. The high interest rates on the loans made for bonds with high yields that investors savored. New technology helped make it easier for lenders to collect and collate mounds of information on borrowers.

And thus the great housing boom was born, goosed into an ever greater frenzy by ever more innovative mortgage lending strategies that kept the party going on and on and on.

Until the music stopped. Until too many risky loans were made and too many homes were built. Now borrowers can't make their mortgage payments and lenders are foreclosing. And the cushion protecting against those defaults is proving not to be so soft after all.

Which brings us back to Bill Gross, who is practically screaming that the worst is still to come. Bear Stearns may have, for now, averted the horrifying prospect of revealing to the world what its "toxic waste" is worth, but that's hardly the end of this saga.

Those that point to a crisis averted and a return to normalcy are really looking for contagion in all the wrong places. Because the problem lies not in a Bear Stearns hedge fund that can be papered over with 100 cents on the dollar marks. The flaw resides in the Summerlin suburbs of Las Vegas, Nevada, in the extended city limits of Chicago headed west towards Rockford, and yes, the naked (and empty) rows of multistoried condos in Miami, Florida. The flaw, dear readers, lies in the homes that were financed with cheap and in some cases gratuitous money in 2004, 2005, and 2006. Because while the Bear hedge funds are now primarily history, those millions and millions of homes are not. Theyb

Gross quotes Bank of America research that declares that $500 billion dollars worth of adjustable rate mortgages are going to reset in 2007 -- meaning that mortgage payments are going to leap up for many thousands of home-owners. The number for 2008 is even bigger -- $700 billion. Given the current continuing weakness in the housing market, the impact of those higher mortgage payments seems sure to result in even more missed payments and foreclosures, and even more pressure on the current owners of mortgage-backed CDOs.

Maybe the hedge funds can take the blow. The standard line from the defenders of complex bundled financial products is that they have helped to diversify risk more widely than ever before, thus insulating the entire global economy from the impact of any one shock. So far, they've been proven right. The dot-com bust didn't sink Wall Street, nor did Enron and Worldcom, or Long Term Capital Management and Amaranth.

SEC Chairman Chris Cox is one of the defenders of the status quo, a man who generally believes that more regulation and oversight of Wall Street is unnecessary. The fact that the SEC has so many investigations under way is reason enough to take notice. But the fact that any such action may be happening long after this train wreck in motion started crumpling boxcars together is what's really sending chills through Wall Street.

By Andrew Leonard

Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21.

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