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Subject:  Re: Sub prime hedgie troubles Date:  6/22/2007  5:27 PM
Author:  Alfred4 Number:  20816 of 35593

The few hedge funds that I am familiar with do not engage in day trading. One of them makes equipment lease loans at very high rates with the capital item as security (they get rates in excess of 18% plus a 3% origination fee, a very good business). Another one invests in deeply distressed companies. And another one has been buying heavily discounted mortgage paper. Talk about high risk!

I would like to thank all of you for all the knowledge you so generously share. I have enjoyed your posts for several years now. So it's past time that I give something back. I hesitate to write because my writing skills are so lacking and you get murdered on these boards for miss spelling or grammatical errors.

What brings me to write is I have gained by chance some information about credit risks that may be useful to you. Namely “who really gets left holding the bag when mortgages default and just how risky are Mortgage Backed Securities”.

My wife and I was guest this weekend with a couple whose husband works in the commercial capital markets (not the residential capital markets but both are structured in the same way.) After a polite amount of time I asked “What do you do in the capital markets”? He said we securitize commercial mortgages. Wow! I never dreamed I would talk one on one with some one who could explain in detail how the MBS system and tranches work.

So I put the question to him “who really get left holding the bag when these MBS bonds default?”

He, being a patient type, first explained how the pool of mortgages is assembled from portfolios of mortgages that they buy from originators and later securitize.

The process:

A skilled clerk examines each mortgage in a portfolio of mortgages and makes a notation of the quality of each mortgage then puts it in a pile that is now referred to as The Pool.

The next step is to mentally divide the Pool into tranches. Tranches are a concept of risk and not a physical division of the mortgages in the pool.

The securitizer, sometimes with the help of software, calculates how many bonds are to be issued for each of the tranches. The different tranches represent different degrees of risk. The top tranch has very little risk and pays the least interest of all the tranches where as the lowest tranch has considerable risk but pays the most the range of 18% or better. The interest rates paid on the tranches is based on the 10 yr treasure bond plus a varying number of basis points added depending on the risk of the tranch.
Bonds are then issued on each tranch. Fewer bonds are issued on the lowest tranch than the other tranches and all the tranches are backed by the very same pool!

My next question was to define what is considerable risk? How is risk assigned?

Now no one really signs an affidavit but if they did it would make it very easy to explain the meaning and significance of a tranch and how risks are dristributed.

. Let's pretend all the people in the lowest tranch had signed an affidavit or agreement
that said “we the members of the lowest tranch are willing to stand good for all the grief (non payments of loans, early repayments of loans and all costs associated with foreclosures) coming from any and all loans in the entire pool if you will pay us 18% interest”. Let's further pretend all the people in the tranches above the lowest have signed similar affidavits but demanded a lower rate of interest than the bond holders in the tranches below them.

Now no one really signs such an agreement but it comes very close to explaining the way risks are assigned. The lowest tranch assumes 100% of the risks until they are wiped out! The honor is then past to the next tranch above. (No one in the upper tranches is ever out one penny until the tranch below is wiped out.)

The pe